Chapter 1 - 7: Technical Analysis Of The Financial Markets Audiobook

[00:00:00] Speaker 1: welcome back to Trading for Life. If you're serious about trading, then mastering technical analysis is a must. But with so many books out there, where do you start? Well, today, I'm introducing you to a true classic John J. Murphy's technical analysis of the financial markets. Whether you're a beginner or an advanced trader, this audiobook is packed with everything you need to analyze price action and make better trading decisions. This book is considered the Bible of technical analysis. How to read price charts and patterns, moving averages, RSI, MACD, Bollinger Bands, and other key indicators. How to identify trends and reversals with technical tools, intermarket analysis, how different markets affect each other. In short, this audiobook gives you a step-by-step guide to reading the markets like a pro. So why should you listen to this audiobook? Here's what makes it valuable. It simplifies complex trading concepts, making them easy to understand. You'll learn how to use indicators to time your trades better. It teaches you how to analyze multiple markets together. Stocks, forex, commodities, and even crypto. Whether you're a beginner looking to build a strong foundation or an experienced trader wanting to refine your strategies, this book has something for you. The best part? You can listen to it on the go. The knowledge inside can help you take your trading to the next level. Want more trading book recommendations? Let me know in the comments which book you want me to cover next. And don't forget to like, subscribe, and hit the bell icon so you never miss an update on trading education. See you in the next video. Trade smart and stay disciplined. Technical Analysis of the Financial Markets A Comprehensive Guide to Trading Methods and Applications by John J. Murphy Introduction I had no idea when Technical Analysis of the Futures Markets was published in 1986 that it would create such an impact on the industry. It has been referred to by many in the field as the Bible of technical analysis. The Market Technicians Association uses it as a primary source in their testing process for the chartered market technician program. Federal Reserve has cited it in research studies that examine the value of the technical approach. In addition, it has been translated into eight foreign languages. It was also unprepared for the long shelf life of the book. It continues to sell as many copies 10 years after it was published as it did in the first couple of years. It became clear, however, that a lot of new material had been added to the field of technical analysis in the past decade. I added some of it myself. My second book, Intermarket Technical Analysis, Wiley 1991, helped create that new branch of technical analysis which is widely used today. Old techniques like Japanese candlestick charting and newer ones like market profile have become part of the technical landscape. Clearly, this new work needed to be included in any book that attempted to present a comprehensive picture of technical analysis. The focus of my work changed as well. While my main interest 10 years ago was in the futures markets, my recent work has dealt more with the stock market. That also brought me full circle since I began my career as a stock analyst 30 years ago. That was also one of the side effects of my being the technical analyst for CNBC TV for seven years. That focus on what the general public was doing also led to my third book, The Visual Investor, Wiley 1996. That book focused on the use of technical tools for market sectors, primarily through mutual funds, which have become extremely popular in the 1990s. Many of the technical indicators that I wrote about 10 years ago, which had been used primarily in the futures markets, have been incorporated into stock market work. It was time to show how that was being done. Finally, like any field or discipline, writers also evolve. Some things that seemed very important to me 10 years ago aren't as important today. As my work has evolved into a broader application of technical principles to all financial markets, it seemed only right that any revision of that earlier work should reflect that evolution. I've tried to retain the structure of the original book. Therefore, many of the original chapters remain. However, they have been revised with new material and updated with new graphics. Since the principles of technical analysis are universal, it wasn't that difficult to broaden the focus to include all financial markets. Since the original focus was on futures, however, a lot of stock market material has been added. Three new chapters have been added. The two previous chapters on point and figure charting, chapters 11 and 12, have been merged into one. A new chapter 12 on candlestick charting has been inserted. Two additional chapters have also been added at the end of the book. Chapter 17 is an introduction to my work on intermarket analysis. Chapter 18 deals with stock market indicators. We've replaced the previous appendices with new ones. Market profile is introduced in Appendix B. The other appendices show some of the more advanced technical indicators and explain how to build a technical trading system. There's also a glossary. I approached this revision with some trepidation. I wasn't sure redoing a book considered a classic was such a good idea. I hope I've succeeded in making it even better. I approached this work from the perspective of a more seasoned and mature writer and analyst. And, throughout the book, I tried to show the respect I have always had for the discipline of technical analysis, and for the many talented analysts who practice it. The success of their work, as well as their dedication to this field, has always been a source of comfort and inspiration to me. I only hope I did justice to it, and to them. John Murphy. Chapter 1. Philosophy of Technical Analysis. Introduction. Before beginning a study of the actual techniques and tools used in technical analysis, it is necessary first to define what technical analysis is, to discuss the philosophical premises on which it is based, to draw some clear distinctions between technical and fundamental analysis, and, finally, to address a couple of criticisms frequently raised against the technical approach. The author's strong belief is that a full appreciation of the technical approach must begin with a clear understanding of what technical analysis claims to be able to do, and, maybe even more importantly, the philosophy or rationale on which it bases those claims. First, let's define the subject. Technical analysis is the study of market action, primarily through the use of charts, for the purpose of forecasting future price trends. A term. The term market action includes the three principal sources of information available to the technician: price, volume, and open interest. Babtion. Open interest is used only in futures and options. The term price action, which is often used, seems too narrow because most technicians include volume and open interest as an integral part of their market analysis. With this distinction made, the terms price action and market action are used interchangeably throughout the remainder of this discussion. Philosophy or rationale. There are three premises on which the technical approach is based. 1. Market action discounts everything. 2. Prices move in trends. 3. History repeats itself. Market action discounts everything. The statement "market action discounts everything" forms what is probably the cornerstone of technical analysis. Unless the full significance of this first premise is fully understood and accepted, nothing else that follows makes much sense. The technician believes that anything that can possibly affect the price, fundamentally, politically, psychologically or otherwise, is actually reflected in the price of that market. It follows, therefore, that a study of price action is all that is required. While this claim may seem presumptuous, it is hard to disagree with if one takes the time to consider its true meaning. All the technician is really claiming is that price action should reflect shifts in supply and demand. If demand exceeds supply, prices should rise. If supply exceeds demand, prices should fall. This action is the basis of all economic and fundamental forecasting. The technician then turns this statement around to arrive at the conclusion that if prices are rising, for whatever the specific reasons, demand must exceed supply, and the fundamentals must be bullish. If prices fall, the fundamentals must be bearish. If this last comment about fundamentals seems surprising in the context of a discussion of technical analysis, it shouldn't. After all, the technician is indirectly studying fundamentals. Most technicians would probably agree that it is the underlying forces of supply and demand, the economic fundamentals of a market, that cause bull and bear markets. The charts do not in themselves cause markets to move up or down. They simply reflect the bullish or bearish psychology of the marketplace. As a rule, chartists do not concern themselves with the reasons why prices rise or fall. Very often, in the early stages of a price trend or at critical turning points, no one seems to know exactly why a market is performing a certain way. While the technical approach may sometimes seem overly simplistic in its claims, the logic behind this first premise that markets discount everything becomes more compelling the more market experience one gains. It follows then that if everything that affects market price is ultimately reflected in market price, then the study of that market price is all that is necessary. By studying price charts and a host of supporting technical indicators, the chartist, in effect, lets the market tell him or her which way it is most likely to go. The chartist does not necessarily try to outsmart or outguess the market. All of the technical tools discussed later on are simply techniques used to aid the chartist in the process of studying market action. The chartist knows there are reasons why markets go up or down. He or she just doesn't believe that knowing what those reasons are is necessary in the forecasting process. Prices move in trends. The concept of trend is absolutely essential to the technical approach. Here again, unless one accepts the premise that markets do in fact trend, there's no point in reading any further. The whole purpose of charting the price action of a market is to identify trends in early stages of their development for the purpose of trading in the direction of those trends. In fact, most of the techniques used in this approach are trend following in nature, meaning that their intent is to identify and follow existing trends. See figure 1.1. There is a corollary to the premise that prices move in trends. A trend in motion is more likely to continue than to reverse. This corollary is, of course, an adaptation of Newton's first law of motion. Another way to state this corollary is that a trend in motion will continue in the same direction until it reverses. This is another one of those technical claims that seems almost circular. But the entire trend following approach is predicated on riding an existing trend until it shows signs of reversing. History repeats itself. Much of the body of technical analysis and the study of market action has to do with the study of human psychology. Chart patterns, for example, which have been identified and categorized over the past 100 years, reflect certain pictures that appear on price charts. These pictures reveal the bullish or bearish psychology of the market. Since these patterns have worked well in the past, it is assumed that they will continue to work well in the future. They are based on the study of human psychology, which tends not to change. Another way of saying this last premise that history repeats itself is that the key to understanding the future lies in a study of the past, or that the future is just a repetition of the past. Technical vs. Fundamental Forecasting While technical analysis concentrates on the study of market action, fundamental analysis focuses on the economic forces of supply and demand that cause prices to move higher, lower, or stay the same of you. The fundamental approach examines all of the relevant factors affecting the price of a market in order to determine the intrinsic value of that market. The intrinsic value is what the fundamentals indicate something is actually worth based on the law of supply and demand. If this intrinsic value is under the current market price, then the market is overpriced and should be sold. If market price is below the intrinsic value, then the market is undervalued and should be bought. Both of these approaches to market forecasting attempt to solve the same problem, that is, to determine the direction prices are likely to move. They just approach the problem from different directions. The fundamentalist studies the cause of market movement, while the technician studies the effect. The technician, of course, believes that the effect is all that he or she wants or needs to know, and that the reasons, or the causes, are unnecessary. The fundamentalist always has to know why. Most traders classify themselves as either technicians or fundamentalists. In reality, there is a lot of overlap. Many fundamentalists have a working knowledge of the basic tenets of chart analysis. At the same time, many technicians have at least a passing awareness of the fundamentals. The problem is that the charts and fundamentals are often in conflict with each other. Usually, at the beginning of important market moves, the fundamentals do not explain or support what the market seems to be doing. It is at these critical times in the trend that these two approaches seem to differ the most. Usually, they come back into sync at some point, but often too late for the trader to act. One explanation for these seeming discrepancies is that market price tends to lead the known fundamentals. Stated another way, market price acts as a leading indicator of the fundamentals or the conventional wisdom of the moment. While the known fundamentals have already been discounted and are already in the market, prices are now reacting to the unknown fundamentals. Some of the most dramatic bull and bear markets in history have begun with little or no perceived change in the fundamentals. By the time those changes became known, the new trend was well underway. After a while, the technician develops increased confidence in his or her ability to read the charts. The technician learns to be comfortable in a situation where market movement disagrees with the so-called conventional wisdom. A technician begins to enjoy being in the minority. He or she knows that eventually the reasons for market action will become common knowledge. It is just that the technician isn't willing to wait for that added confirmation. In accepting the premises of technical analysis, one can see why technicians believe their approach is superior to the fundamentalists. If a trader had to choose only one of the two approaches to use, the choice would logically have to be the technical. Because, by definition, the technical approach includes the fundamental. If the fundamentals are reflected in market price, then the study of those fundamentals becomes unnecessary. Chart reading becomes a shortcut form of fundamental analysis. The reverse, however, is not true. Fundamental analysis does not include a study of price action. It is possible to trade financial markets using just the technical approach. It is doubtful that anyone could trade off the fundamentals alone, with no consideration of the technical side of the market. Analysis versus timing. This last point is made clearer if the decision-making process is broken down into two separate stages: analysis and timing. Because of the high leverage factor in the futures markets, timing is especially crucial in that arena. It is quite possible to be correct on the general trend of the market and still lose money. Because margin requirements are so low in futures trading, usually less than 10%, a relatively small price move in the wrong direction can force the trader out of the market with the resulting loss of all or most of that margin. In stock market trading, by contrast, a trader who finds him or herself on the wrong side of the market can simply decide to hold onto the stock, hoping that it will stage a comeback at some point. Futures traders don't have that luxury. A buy-and-hold strategy doesn't apply to the futures arena. Both the technical and the fundamental approach can be used in the first phase: the forecasting process. However, the question of timing, of determining specific entry and exit points, is almost purely technical. Therefore, considering the steps the trader must go through before making a market commitment, it can be seen that the correct application of technical principles becomes indispensable at some point in the process, even if fundamental analysis was applied in the earlier stages of the decision. Timing is also important in individual stock selection and in the buying and selling of stock market sector and industry groups. Flexibility and Adaptability of Technical Analysis One of the great strengths of technical analysis is its adaptability to virtually any trading medium and time dimension. There, there is no area of trading in either stocks or futures where these principles do not apply. The chartist can easily follow as many markets as desired, which is generally not true of his or her fundamental counterpart. Because of the tremendous amount of data the latter must deal with, most fundamentalists tend to specialize. The advantages here should not be overlooked. For one thing, markets go through active and dormant periods, trending and non-trending stages. The technician can concentrate his or her attention and resources in those markets that display strong trending tendencies and choose to ignore the rest. As a result, the chartist can rotate his or her attention and capital to take advantage of the rotational nature of the markets. At different times, certain markets become hot and experience important trends. Usually, those trending periods are followed by quiet and relatively trendless market conditions, while another market or group takes over. The technical trader is free to pick and choose. The fundamentalist, however, who tends to specialize in only one group, doesn't have that kind of flexibility. Even if he or she were free to switch groups, the fundamentalist would have a much more difficult time doing so than would the chartist. Another advantage the technician has is the big picture. By following all of the markets, he or she gets an excellent feel for what markets are doing in general and avoids the tunnel vision that can result from following only one group of markets. Also, because so many of the markets have built-in economic relationships and react to similar economic factors, price action in one market or group may give valuable clues to the future direction of another market or group of markets. Technical analysis applied to different trading mediums. The principles of chart analysis applied to both stocks and futures. Actually, technical analysis was first applied to the stock market and later adapted to futures. With the introduction of stock index futures, the dividing line between these two areas is rapidly disappearing. International stock markets are also charted and analyzed according to technical principles. See figure 1.2. Financial futures, including interest rate markets and foreign currencies, have become enormously popular over the past decade and have proven to be excellent subjects for chart analysis. Technical principles play a role in options trading. Technical forecasting can also be used to great advantage in the hedging process. Technical analysis applied to different time dimensions. Another strength of the charting approach is its ability to handle different time dimensions. Whether the user is trading the intraday tick by paric changes for day trading purposes or trend trading the intermediate trend, the same principles apply. A time dimension often overlooked is longer range technical forecasting. The opinion expressed in some quarters that charting is useful only in the short term is simply not true. It has been suggested by some that fundamental analysis should be used for long term forecasting with technical factors limited to short term timing. The fact is that longer range forecasting, using weekly and monthly charts going back several years, has proven to be an extremely useful application of these techniques. Once the technical principles discussed in this book are thoroughly understood, they will provide the user with tremendous flex ion ability as to how they can be applied, both from the standpoint of the medium to be analyzed and the time dimension to be studied. Economic forecasting. Technical analysis can play a role in economic forecasting. For example, the direction of commodity prices tells us something about the direction of inflation. They also give us clues about the strength or weakness of the economy. Rising commodity prices generally hint at a stronger economy and rising inflationary pressure. Falling commodity prices usually warn that the economy is slowing along with inflation. The direction of interest rates is affected by the trend of commodities. As a result, charts of commodity markets like gold and oil, along with treasury bonds, can tell us a lot about the strength or weakness of the economy and inflationary expectations. The direction of the US dollar and foreign currency futures also provide early guidance about the strength or weakness of the respective global economies. Even more impressive is the fact that trends in these futures markets usually show up long before they are reflected in traditional economic indicators that are released on a monthly or quarterly basis and usually tell us what has already happened. As their name implies, futures markets usually give us insights into the future. The S&P 500 stock market index has long been counted as an official leading economic indicator. A book by one of the country's top experts on the business cycle, Leading Indicators for the 1990s, Moore, makes a compelling case for the importance of commodity, bond, and stock trends as economic indicators. All three markets can be studied employing technical analysis. We'll have more to say on this subject in Chapter 17: The Link Between Stocks and Futures Technician or Chartist There are several different titles applied to practitioners of the technical approach: Technical Analyst, Chartist, Market Analyst, and Visual Analyst. Up until recently, they all meant pretty much the same thing. However, with increased specialization in the field, it has become necessary to make some further distinctions and define the terms a bit more carefully. Because virtually all technical analysis was based on the use of charts up until the last decade, the terms technician and chartist meant the same thing. This is no longer necessarily true. The broader area of technical analysis is being increasingly divided into two types of practitioners: the traditional chartist and, for want of a better term, statistical technicians. Admittedly, there is a lot of overlap here, and most technicians combine both areas to some extent. As in the case of the technician versus the fundamentalist, most seem to fall into one category or the other. Whether or not the traditional chartist uses quantitative work to supplement his or her analysis, charts remain the primary working tool. Everything else is secondary. Charting, of necessity, remains somewhat subjective. The success of the approach depends, for the most part, on the skill of the individual chartist. The term "art charting" has been applied to this approach because chart reading is largely an art. By contrast, the statistical analyst takes these subjective principles, quantifies, tests, and optimizes them for the purpose of developing mechanical trading systems. These systems, or trading models, are then programmed into a computer that generates mechanical buy and sell signals. These systems range from the simple to the very complex. However, the intent is to reduce or completely eliminate the subjective human element in trading, to make it more scientific. These statisticians may or may not use price charts in their work, but they are considered technicians, as long as their work is limited to the study of market action. Even computer technicians can be subdivided further into those who favor mechanical systems, or the black box approach, and those who use computer technology to develop better technical indicators. The latter group maintains control over the interpretation of those indicators, and also the decision-making process. One way of distinguishing between the chartist and the statistician is to say that all chartists are technicians, but not all technicians are chartists. Although these terms are used interchangeably throughout this book, it should be remembered that charting represents only one area in the broader subject of technical analysis. A brief comparison of technical analysis in stocks and futures. A question often asked is whether technical analysis as applied to futures is the same as the stock market. The answer is both yes and no. The basic principles are the same, but there are some significant differences. The principles of technical analysis were first applied to stock market forecasting, and only later adapted to futures. Most of the basic tools – bar charts, point and figure charts, price patterns, volume, trend lines, moving averages, and oscillators, for example – are used in both areas. Anyone who has learned these concepts in either stocks or futures wouldn't have too much trouble making the adjustment to the other side. However, there are some general areas of difference, having more to do with the different nature of stocks and futures than with the actual tools themselves. Pricing structure The pricing structure in futures is much more complicated than in stocks. Each commodity is quoted in different units and increments. Grain markets, for example, are quoted in cents per bushel. Livestock markets in cents per pound, gold and silver in dollars per ounce, and interest rates in basis points. A trader must learn the contract details of each market, which exchange it is traded on, how each contract is quoted, what the minimum and maximum price increments are, and what these price increments are worth. Limited lifespan Unlike stocks, futures contracts have expiration dates. A March 1999 Treasury bond contract, for example, expires in March of 1999. The typical futures contract trades for about a year and a half before expiration. Therefore, at any one time, at least a half dozen different contract months are trading in the same commodity at the same time. The trader must know which contracts to trade and which ones to avoid. This is explained later in this book. This limited life feature causes some problems for longer range price forecasting. It necessitates the continuing need for obtaining new charts once old contracts stop trading. The chart of an expired contract isn't of much use. New charts must be obtained for the newer contracts along with their own technical indicators. This constant rotation makes the maintenance of an ongoing chart library a good deal more difficult. For computer users, it also entails greater time and expense by making it necessary to be constantly obtaining new historical data as old contracts expire. Lower margin requirements This is probably the most important difference between stocks and futures. All futures are traded on margin, which is usually less than 10% of the value of the contract. The result of these low margin requirements is tremendous leverage. Relatively small price moves in either direction tend to become magnified in their impact on overall trading results. For this reason, it is possible to make or lose large sums of money very quickly in futures. Because a trader puts up only 10% of the value of the contract as margin, then a 10% move in either direction will either double the trader's money or wipe it out. By magnifying the impact of even minor market moves, the high leverage factor sometimes makes the futures market seem more volatile than they actually are. When someone says, for example, that he or she was wiped out in the futures market, remember that he or she only committed 10% in the first place. From the standpoint of technical analysis, the high leverage factor makes timing in the futures markets much more critical than it is in stocks. The correct timing of entry and exit points is crucial in futures trading and much more difficult and frustrating than market analysis. Largely for this reason, technical trading skills become indispensable to a successful futures trading program. The time frame is much shorter. Because of the high leverage factor and the need for close monitoring of market positions, the time horizon of the commodity trader is much shorter of necessity. Stock market technicians tend to look more at the longer range picture and talk in timeframes that are beyond the concern of the average commodity trader. Stock technicians may talk about where the market will be in three or six months. Futures traders want to know where prices will be next week, tomorrow, or maybe even later this afternoon. This has necessitated the refinement of very short-term timing tools. One example is the moving average. The most commonly watched averages in stocks are 50 and 200 days. In commodities, most moving averages are under 40 days. A popular moving average combination in futures, for example, is 4, 9, and 18 days. Greater reliance on timing. Timing is everything in futures trading. Determining the correct direction of the market only solves a portion of the trading problem. If the timing of the entry point is off by a day, or sometimes even minutes, it can mean the difference between a winner or a loser. It's bad enough to be on the wrong side of the market and lose money. Being on the right side of the market and still losing money is one of the most frustrating and unnerving aspects of futures trading. It goes without saying that timing is almost purely technical in nature, because the fundamentals rarely change on a day-to-day basis. Less reliance on market averages and indicators. Stock market analysis is based heavily on the movement of broad market averages, such as the Dow Jones Industrial Average or the S&P 500. In addition, technical indicators that measure the strength or weakness of the broader market, like the NYSE Advanced Decline Line or the New Highs/New Lows list, are heavily employed. While commodity markets can be tracked using measures like the Commodity Research Bureau Futures Price Index, less emphasis is placed on the broader market approach. Commodity market analysis concentrates more on individual market action. That being the case, technical indicators that measure broader commodity trends aren't used much. With only about 20 or so active commodity markets, there isn't much need. Specific Technical Tools While most of the technical tools originally developed in the stock market have some application in commodity markets, they are not used in the exact same way. For example, chart patterns in futures often tend not to form as fully as they do in stocks. Futures traders rely more heavily on shorter-term indicators that emphasize more precise trading signals. These points of difference, and many others, are discussed later in this book. Finally, there is another area of major difference between stocks and futures. Technical analysis in stocks relies much more heavily on the use of sentiment indicators and flow of funds analysis. Sentiment indicators monitor the performance of different groups such as odd lotters, mutual funds, and floor specialists. Enormous importance is placed on sentiment indicators that measure the overall market bullishness and bearishness on the theory that the majority opinion is usually wrong. Flow of funds analysis refers to the cash position of different groups such as mutual funds or large institutional accounts. The thinking here is that the larger the cash position, the more funds that are available for stock purchases. Technical analysis in the futures markets is a much purer form of price analysis. While contrary opinion theory is also used to some extent, much more emphasis is placed on basic trend analysis and the application of traditional technical indicators. Some criticisms of the technical approach A few questions generally crop up in any discussion of the technical approach. One of these concerns is the self-fulfilling prophecy. Another is the question of whether or not past price data can really be used to forecast future price direction. The critic usually says something like, "Charts tell us where the market has been, but can't tell us where it is going." For the moment, we'll put aside the obvious answer that a chart won't tell you anything if you don't know how to read it. The random walk theory questions whether prices trend at all and doubts that any forecasting technique can beat a simple buy and hold strategy. These questions deserve a response. The Self-Fulfilling Prophecy The question of whether there is a self-fulfilling prophecy at work seems to bother most people because it is raised so often. It is certainly a valid concern, but of much less importance than most people realize. Perhaps the best way to address this question is to quote from a text that discusses some of the disadvantages of using chart patterns. A. The use of most chart patterns has been widely publicized in the last several years. Many traders are quite familiar with these patterns and often act on them in concert. This creates a self-fulfilling prophecy as waves of buying or selling are created in response to bullish or bearish patterns. B. Chart patterns are almost completely subjective. Now, no study has yet succeeded in mathematically quantifying any of them. They are literally in the mind of the beholder. To Willis et al. These two criticisms contradict one another and the second point actually cancels out the first. If chart patterns are completely subjective and in the mind of the beholder, then it is hard to imagine how everyone could see the same thing at the same time, which is the basis of the self-fulfilling prophecy. Critics of charting can't have it both ways. They can't, on the one hand, criticize charting for being so objective and obvious that everyone will act in the same way at the same time, thereby causing the price pattern to be fulfilled, and then also criticize charting for being too subjective. The truth of the matter is that charting is very subjective. Chart reading is an art. Possibly the word skill would be more to the point. Chart patterns are seldom so clear that even experienced chartists always agree on their interpretation. There is always an element of doubt and disagreement. As this book demonstrates, there are many different approaches to technical analysis that often disagree with one another. Even if most technicians did agree on a market forecast, they would not all necessarily enter the market at the same time and in the same way. Some would try to anticipate the chart signal and enter the market early. Others would buy the breakout from a given pattern or indicator. Still others would wait for the pullback after the breakout before taking action. Some traders are aggressive. Others are conservative. Some use stops to enter the market, while others like to use market orders or resting limit orders. Some are trading for the long pull, while others are day trading. Therefore, the possibility of all technicians acting at the same time and in the same way is actually quite remote. Even if the self-fulfilling prophecy were of major concern, it would probably be self-correcting in nature. In other words, traders would rely heavily on charts until their concerted actions started to affect or distort the markets. Once traders realized this was happening, they would either stop using the charts or adjust their trading tactics. For example, they would either try to act before the crowd or wait longer for greater confirmation. So even if the self-fulfilling prophecy did become a problem over the near term, it would tend to correct itself. It must be kept in mind that bull and bear markets only occur and are maintained when they are justified by the law of supply and demand. Technicians could not possibly cause a major market move just by the sheer power of their buying and selling. If this were the case, technicians would all become wealthy very quickly. Of much more concern than the chartists is the tremendous growth in the use of computerized technical trading systems in the futures market. These systems are mainly trend-following in nature, which means that they are all programmed to identify and trade major trends. With the growth in professionally managed money in the futures industry and the proliferation of multi-million dollar public and private funds, most of which are using these technical systems, tremendous concentrations of money are chasing only a handful of existing trends. Because the universe of futures markets is still quite small, the potential for these systems distorting short-term price action is growing. However, even in cases where distortions do occur, they are generally short-term in nature and do not cause major moves. Here again, even the problem of concentrated sums of money using technical systems is probably self-correcting. If all of the systems started doing the same thing at the same time, traders would make adjustments by making their systems either more or less sensitive. The self-fulfilling prophecy is generally listed as a criticism of charting. It might be more appropriate to label it as a compliment. After all, for any forecasting technique to become so popular that it begins to influence events, it would have to be pretty good. We can only speculate as to why this concern is seldom raised regarding the use of fundamental analysis. Can the past be used to predict the future? Another question often raised concerns the validity of using past price data to predict the future. It is surprising how often critics of the technical approach bring up this point, because every known method of forecasting, from weather predicting to fundamental analysis, is based completely on the study of past data. What other kind of data is there to work with? The field of statistics makes a distinction between descriptive statistics and inductive statistics. Descriptive statistics refers to the graphical presentation of data, such as the price data on a standard bar chart. Inductive statistics refers to generalizations, predictions, or extrapolations that are inferred from that data. Therefore, the price chart itself comes under the heading of the descriptive, while the analysis technicians perform on that price data, falls into the realm of the inductive. As one statistical text puts it, the first step in forecasting the business or economic future consists, thus, of gathering observations from the past. In the past, Freud and Williams. Chart analysis is just another form of time series analysis, based on a study of the past, which is exactly what is done in all forms of time series analysis. The only type of data anyone has to go on is past data. We can only estimate the future by projecting past experiences into that future. So it seems that the use of past price data to predict the future in technical analysis is grounded in sound statistical concepts. If anyone were to seriously question this aspect of technical forecasting, he or she would have to also question the validity of every other form of forecasting based on historical data, which includes all economic and fundamental analysis. Random walk theory. The random walk theory, developed and nurtured in the academic community, claims that price changes are serially independent and that price history is not a reliable indicator of future price direction. In a nutshell, price movement is random and unpredictable. The theory is based on the efficient market hypothesis, which holds that prices fluctuate randomly about their intrinsic value. It also holds that the best market strategy to follow would be a simple buy and hold strategy as opposed to any attempt to beat the market. While there seems little doubt that a certain amount of randomness or noise does exist in all markets, it's just unrealistic to believe that all price movement is random. This may be one of those areas where empirical observation and practical experience prove more useful than sophisticated statistical techniques, which seem capable of proving anything the user has in mind or incapable of disproving anything. It might be useful to keep in mind that randomness can only be defined in the negative sense of an inability to uncover systematic patterns in price action. The fact that many academics have not been able to discover the presence of these patterns does not prove that they do not exist. The academic debate as to whether markets trend is of little interest to the average market analyst or trader who is forced to deal in the real world where market trends are clearly visible. If the reader has any doubts on this point, a casual glance through any chart book randomly selected will demonstrate the presence of trends in a very graphic way. How do the random walkers explain the persistence of these trends if prices are serially independent, meaning that what happened yesterday or last week has no bearing on what may happen today or tomorrow? How do they explain the profitable, real-life track records of many trend-following systems? How, for example, would a buy-and-hold strategy fare in the commodity futures markets, where timing is so crucial? Would those long positions be held during bear markets? How would traders even know the difference between bull and bear markets if prices are unpredictable and don't trend? In fact, how could a bear market even exist in the first place because that would imply a trend? See Figure 1.3 It seems doubtful that statistical evidence will ever totally prove or disprove the random walk theory. However, the idea that markets are random is totally rejected by the technical community. If the markets were truly random, no forecasting technique would work. Far from disproving the validity of the technical approach, the efficient market hypothesis is very close to the technical premise that markets discount everything. The academics, however, feel that because markets quickly discount all information, there's no way to take advantage of that information. The basis of technical forecasting, already touched upon, is that important market information is discounted in the market price long before it becomes known. Without meaning to, the academics have very eloquently stated the need for closely monitoring price action and the futility of trying to profit from fundamental information, at least over the short term. Finally, it seems only fair to observe that any process appears random and unpredictable to those who do not understand the rules under which that process operates. An electrocardiogram printout, for example, might appear like a lot of random noise to a layperson. But to a trained medical person, all those little blips make a lot of sense and are certainly not random. The working of the markets may appear random to those who have not taken the time to study the rules of market behavior. The illusion of randomness gradually disappears as the skill in chart reading improves. Hopefully, that is exactly what will happen as the reader progresses through the various sections of this book. There may even be hope for the academic world. A number of leading American universities have begun to explore behavioral finance, which maintains that human psychology and securities pricing are intertwined. That, of course, is the primary basis of technical analysis. Universal principles. When an earlier version of this book was published 12 years ago, many of the technical timing tools that were explained were used mainly in the futures markets. Over the past decade, however, these tools have been widely employed in analyzing stock market trends. The technical principles that are discussed in this book can be applied universally to all markets, even mutual funds. One additional feature of stock market trading that has gained wide popularity in the past decade has been sector investing, primarily through index options and mutual funds. Later in the book, we'll show how to determine which sectors are hot and which are not by applying technical timing tools. End of chapter one. Chapter two. Dow Theory. Introduction. Charles Dow and his partner Edward Jones founded Dow Jones & Company in 1882. Most technicians and students of the markets concur that much of what we call technical analysis today has its origins in theories first proposed by Dow around the turn of the century. Dow published his ideas in a series of editorials he wrote for the Wall Street Journal. Most technicians today recognize and assimilate Dow's basic ideas, whether or not they recognize the source. Dow theory still forms the cornerstone of the study of technical analysis, even in the face of today's sophisticated computer technology and the proliferation of newer and supposedly better technical indicators. On July 3, 1884, Dow published the first stock market average composed of the closing prices of 11 stocks, nine railroad companies, and two manufacturing firms. Dow felt that these 11 stocks provided a good indication of the economic health of the country. In 1897, Dow determined that two separate indices would better represent that health and created a 12 stock industrial index and a 20 stock rail index. By 1928, the industrial index had grown to include 30 stocks, the number at which it stands today. The editors of the Wall Street Journal have updated the list numerous times in the ensuing years, adding a utility index in 1929. In 1984, the year that marked the 100th anniversary of Dow's first publication, the Market Technicians Association presented a Gorham Silver Bowl to Dow Jones and Company. According to the MTA, the award recognized the lasting contribution that Charles Dow made to the field of investment analysis. His index, the forerunner of what today is regarded as the leading barometer of stock market activity, remains a vital tool for market technicians 80 years after his death. Unfortunately for us, Dow never wrote a book on his theory. Instead, he set down his ideas of stock market behavior in a series of editorials that the Wall Street Journal published around the turn of the century. In 1903, the year after Dow's death, S.A. Nelson compiled these essays into a book entitled "The ABC of Stock Speculation." In that work, Nelson first coined the term "Dow's Theory." Richard Russell, who wrote the introduction to a 1978 reprint, compared Dow's contribution to stock market theory with Freud's contribution to psychiatry. In 1922, William Peter Hamilton, Dow's associate and successor at the journal, categorized and published Dow's Tenets in a book entitled "The Stock Market Barometer." Robert Rhea developed the theory even further in "The Dow Theory," New York, Barron's, published in 1932. Dow applied his theoretical work to the stock market averages that he created, namely, the industrials and the rails. However, most of his analytical ideas apply equally well to all market averages. This chapter will describe the six basic tenets of Dow theory, and will discuss how these ideas fit into a modern study of technical analysis. We will discuss the ramifications of these ideas in the chapters that follow. Basic Tenets 1. The averages discount everything. The sum and tendency of the transactions of the stock exchange represent the sum of all Wall Street's knowledge of the past, immediate and remote, applied to the discounting of the future. There is no need to add to the averages, as some statisticians do, elaborate compilations of commodity price index numbers, bank clearings, fluctuations in exchange, volume of domestic and foreign trades, or anything else. Wall Street considers all these things. Hamilton, PP 40 to 41. Sound familiar? The idea that the markets reflect every possible knowable factor that affects overall supply and demand is one of the basic premises of technical theory, as was mentioned in Chapter 1. The theory applies to market averages, as well as it does to individual markets, and even makes allowances for acts of God. While the markets cannot anticipate events such as earthquakes and various other natural calamities, they quickly discount such occurrences, and almost instantaneously assimilate their affects into the price action. 2. The market has three trends. Before discussing how trends behave, we must clarify what Dow considered a trend. Dow defined an uptrend as a situation in which each successive rally closes higher than the previous rally highs, and each successive rally low also closes higher than the previous rally low. In other words, an uptrend has a pattern of rising peaks and troughs. The opposite situation, with successively lower peaks and troughs, defines a downtrend. Dow's definition has withstood the test of time and still forms the cornerstone of trend analysis. Dow believed that the laws of action and reaction apply to the markets just as they do to the physical universe. He wrote, "Records of trading show that in many cases, when a stock reaches top, it will have a moderate decline and then go back again to near the highest figures. If after such a move, the price again recedes, it is liable to decline some distance." Nelson, page 43. Dow considered a trend to have three parts: primary, secondary, and minor, which he compared to the tide, waves, and ripples of the sea. The primary trend represents the tide, the secondary or intermediate trend represents the waves that make up the tide, and the minor trends behave like ripples on the waves. An observer can determine the direction of the tide by noting the highest point on the beach reached by successive waves. If each successive wave reaches further inland than the preceding one, the tide is flowing in. When the high point of each successive wave recedes, the tide has turned out and is ebbing. Unlike actual ocean tides, which last a matter of hours, Dow conceived of market tides as lasting for more than a year, and possibly for several years. The secondary, or intermediate, trend represents corrections in the primary trend and usually lasts three weeks to three months. These intermediate corrections generally retrace between one-third and two-thirds of the previous trend movement, and most frequently, about half or 50% of the previous move. According to Dow, the minor, or near-term, trend usually lasts less than three weeks. This near-term trend represents fluctuations in the intermediate trend. We will discuss trend concepts in greater detail in Chapter 4: Basic Concepts of Trends, where you will see that we continue to use the same basic concepts and terminology today. 3. Major trends have three phases. Dow focused his attention on primary or major trends, which he felt usually take place in three distinct phases. An accumulation phase, a public participation phase, and a distribution phase. The accumulation phase represents informed buying by the most astute investors. If the previous trend was down, then at this point, these astute investors recognize that the market has assimilated all the so-called "bad news." The public participation phase, where most technical trend followers begin to participate, occurs when prices begin to advance rapidly and business news improves. The distribution phase takes place when newspapers begin to print increasingly bullish stories, when economic news is better than ever, and when speculative volume and public participation increase. During this last phase, the same informed investors who began to accumulate near the bear market bottom, when no one else wanted to buy, begin to distribute before anyone else starts selling. Students of Elliott Wave Theory will recognize this division of a major bull market into three distinct phases. R.N. Elliott elaborated upon Ria's work in Dow Theory to recognize that a bull market has three major upward movements. In Chapter 13, Elliott Wave Theory will show the close similarity between Dow's three phases of a bull market and the five-wave Elliott sequence. 4. The averages must confirm each other. Dow, in referring to the industrial and rail averages, meant that no important bull or bear market signal could take place, unless both averages gave the same signal, thus confirming each other. He felt that both averages must exceed a previous secondary peak to confirm the inception or continuation of a bull market. He did not believe that the signals had to occur simultaneously, but recognized that a shorter length of time between the two signals provided stronger confirmation. When the two averages diverged from one another, Dow assumed that the prior trend was still maintained. Elliott Wave Theory only requires that signals be generated in a single average. Chapter 6, Continuation Patterns, will cover the key concepts of confirmation and divergence. See Figures 2.1 and 2.2. 5. Volume Must Confirm the Trend. Dow recognized volume as a secondary but important factor in confirming price signals. Simply stated, volume should expand or increase in the direction of the major trend. In a major uptrend, volume would then increase as prices move higher and diminish as prices fall. In a downtrend, volume should increase as prices drop and diminish as they rally. Dow considered volume a secondary indicator. He based his actual buy and sell signals entirely on closing prices. In Chapter 7, Volume and Open Interest, we'll cover the subject of volume and build on Dow's ideas. Today's sophisticated volume indicators help determine whether volume is increasing or falling off. Savvy traders then compare this information to price action to see if the two are confirming each other. 6. A trend is assumed to be in effect until it gives definite signals that it has reversed. This tenet, which we touched upon in Chapter 1, forms much of the foundation of modern trend-following approaches. It relates a physical law to market movement, which states that an object in motion, in this case a trend, tends to continue in motion until some external force causes it to change direction. 7. A Number A number of technical tools are available to traders to assist in the difficult task of spotting reversal signals, including the study of support and resistance levels, price patterns, trend lines, and moving averages. Some indicators can provide even earlier warning signals of loss of momentum. All of that are notwithstanding, the odds usually favor that the existing trend will continue. The most difficult task for a Dow theorist, or any trend follower for that matter, is being able to distinguish between a normal secondary correction in an existing trend and the first leg of a new trend in the opposite direction. Dow theorists often disagree as to when the market gives an actual reversal signal. Figures 2.3 A and 2.3 B show how this disagreement manifests itself. Figures 2.3 A and 2.3 B illustrate two different market scenarios. In figure 2.3 A, notice that the rally at point C is lower than the previous peak at A. Price then declines below point B. The presence of these two lower peaks and two lower troughs gives a clear-cut sell signal at the point where the low at B is broken, point S. This reversal pattern is sometimes referred to as a failure swing. In figure 2.3 B, the rally top at C is higher than the previous peak at A. Then price declines below point B. Some Dow theorists would not consider the clear violation of support, at SI, to be a bona fide A sell signal. They would point out that only lower lows exist in this case, but not lower highs. They would prefer to see a rally to point E which is lower than point C. Then, they would look for another new low under point D. To them, S2 would represent the actual sell signal with two lower highs and two lower lows. The reversal pattern shown in figure 2.3 B is referred to as a non-failure swing. A failure swing, shown in figure 2.3 A, is a much weaker pattern than the non-failure swing in figure 2.3 B. Figures 2.4 A and 2.4 B show the same scenarios at a market bottom. The use of closing prices and the presence of lines, Dow relied exclusively on closing prices. He believed that averages had to close higher than a previous peak or lower than a previous trough to have significance. Dow did not consider intraday penetrations valid. When traders speak of lines in the averages, they are referring to horizontal patterns that sometimes occur on the charts. These sideways trading ranges usually play the role of corrective phases and are usually referred to as consolidations. In more modern terms, we might refer to such lateral patterns as "rectangles". Some Criticisms of Dow Theory Dow Theory has done well over the years in identifying major bull and bear markets, but has not escaped criticism. On average, Dow Theory misses 20-25% of a move before generating a signal. Many traders consider this to be too late. A Dow Theory buy signal usually occurs in the second phase of an uptrend, as price penetrates a previous intermediate peak. This is also, incidentally, about where most trend-following technical systems begin to identify and participate in existing trends. In response to this criticism, traders must remember that Dow never intended to anticipate trends, rather he sought to recognize the emergence of major bull and bear markets and to capture the large middle portion of important market moves. Available records suggest that Dow's theory has performed that function reasonably well. From 1920 to 1975, Dow Theory's signals captured 68% of the moves in the industrial and transportation averages and 67% of those in the S&P 500 composite index. Source: Barron's Those who criticize Dow Theory for failing to catch actual market tops and bottoms lack a basic understanding of the trend-following philosophy. Stocks: As economic indicators: Dow apparently never intended to use his theory to forecast the direction of the stock market. He felt its real value was to use stock market direction as a barometric reading of general business conditions. We can only marvel at Dow's vision and genius. In addition, in addition to formulating a great deal of today's price forecasting methodology, he was among the first to recognize the usefulness of stock market averages as a leading economic indicator. Dow Theory Applied to Futures Trading Dow's work considered the behavior of stock averages. While most of that original work has significant application to commodity futures, there are some important distinctions between stock and futures trading. For one thing, Dow assumed that most investors follow only the major trends and would use intermediate corrections for timing purposes only. Dow considered the minor or near-term trends to be unimportant. Obviously, this is not the case in futures trading, in which most traders who follow trends trade the intermediate instead of the major trend. These traders must pay a great deal of attention to minor swings for timing purposes. If a futures trader expected an intermediate uptrend to last for a couple of months, he or she would look for short-term dips to signal purchases. In an intermediate downtrend, the trader would use minor bounces to signal short sales. The minor trend, therefore, becomes extremely important in futures trading. New Ways to Trade the Dow Averages For the first 100 years of its existence, the Dow Jones Industrial Average could only be used as a market indicator. That all changed on October 6, 1997, when futures and options began trading on Dow's venerable average for the first time. The Chicago Board of Trade launched a futures contract on the Dow Jones Industrial Average, while options on the Dow, symbol, DJX, started trading at the Chicago Board Options Exchange. In addition, options were also launched on the Dow Jones Transportation Average, symbol, DJTA, and the Dow Jones Utility Index, symbol, DJUA. In January 1998, the American Stock Exchange started trading the Diamonds Trust, a unit investment trust that mimics the 30 Dow Industrials. In addition, two mutual funds were offered based on the 30 Dow benchmark. Mr. Dow would probably be happy to know that, a century after their creation, it would now be possible to trade his Dow averages and actually put his Dow theory into practice. Conclusion This chapter presented a relatively quick review of the more important aspects of the Dow theory. It will become clear, as you continue through this book, that an understanding and appreciation of Dow theory provides a solid foundation for any study of technical analysis. Much of what is discussed in the following chapters represents some adaptation of Dow's original theory. The standard definition of a trend, the classification of a trend into three categories and phases, the principles of confirmation and divergence, the interpretation of volume, and the use of percentage retracements, to name a few, all derive, in one way or another, from Dow theory. In addition to the sources already cited in this chapter, an excellent review of the principles of Dow theory can be found in Technical Analysis of Stock Trends, Edwards and Magee. End of chapter 2. Chapter 3. Chart Construction Introduction This chapter is primarily intended for those readers who are unfamiliar with bar chart construction. We'll begin by discussing the different types of charts available, and then turn our focus to the most commonly used chart, the daily bar chart. We'll look at how the price data is read and plotted on the chart. Volume and open interest are also included in addition to price. We'll then look at other variations of the bar chart, including longer range weekly and monthly charts. Once that has been completed, we'll be ready to start looking at some of the analytical tools applied to that chart in the following chapter. Those readers already familiar with the charts themselves might find this chapter too basic. Feel free to move on to the next chapter. Types of Charts Available The daily bar chart has already been acknowledged as the most widely used type of chart in Technical Analysis. There are, however, other types of charts also used by technicians, such as line charts, point and figure charts, and more recently, candlesticks. Figure 3.1 shows a standard daily bar chart. It's called a bar chart because each day's range is represented by a vertical bar. The bar chart shows the open, high, low, and closing prices. The tick to the right of the vertical bar is the closing price. The opening price is the tick to the left of the bar. Figure 3.2 shows what the same market looks like on a line chart. In the line chart, only the closing price is plotted for each successive day. Many chartists believe that because the closing price is the most critical price of the trading day, a line, or close only chart, is a more valid measure of price activity. A third type of chart, the point and figure chart, is shown in Figure 3.3. Notice here that the point and figure chart shows the same price action, but in a more compressed format. Notice the alternating column of X's and O's. The X columns show rising prices, and the O columns, declining prices. Buy and sell signals are more precise and easier to spot on the point and figure chart than on the bar chart. This type of chart also has a lot more flexibility. Chapter 11 covers point and figure charts. Candlesticks. Candlestick charts are the Japanese version of bar charting, and have become very popular in recent years among Western chartists. The Japanese candlestick records the same four prices as the traditional bar chart: the open, the close, the high, and the low. The visual presentation differs, however. On the candlestick chart, a thin line, called the shadow, shows the day's price range from the high to the low. A wider portion of the bar, called the real body, measures the distance between the open and the close. If the close is higher than the open, the real body is white . If the close is lower than the open, the real body is black . The key to candlestick charts is the relationship between the open and the close. Possibly because of the growing popularity of candlesticks, Western chartists now pay a lot more attention to the opening tick on their bar charts. You can do everything with a candlestick chart that you can do with a bar chart. In other words, all the technical tools and indicators we'll be showing you for the bar chart can also be used on candlesticks. We'll show you a bit later in the chapter how to construct bar charts for weekly and monthly periods. You can do the same with candlesticks. Chapter 12, Japanese Candlesticks, provides a more thorough explanation of candlestick charting. Arithmetic vs. Logarithmic Scale Charts can be plotted using arithmetic or logarithmic price scales. For some types of analysis, particularly for very long-range trend analysis, there may be some advantage to using logarithmic charts. See figures 3.5 and 3.6. Figure 3.5 shows what the different scales would look like. On the arithmetic scale, the vertical price scale shows an equal distance for each price unit of change. Notice in this example that each point on the arithmetic scale is equidistant. On the log scale, however, note that the percentage increases get smaller as the price scale increases. The distance from points 1 to 2 is the same as the distance from points 5 to 10 because they both represent the same doubling in price. For example, a move from 5 to 10 on an arithmetic scale would be the same distance as a move from 50 to 55, even though the former represents a doubling in price, while the latter is a price increase of only 10%. Prices plotted on ratio or log scales show equal distances for similar percentage moves. For example, a move from 10 to 20 would be the same distance on a log chart as a move from 20 to 40 or 40 to 80. Many stock market chart services use log charts, whereas futures chart services use arithmetic. Charting software packages allow both types of scaling, as shown in Figure 3.6. Construction of the daily bar chart The construction of the daily bar chart is extremely simple. The bar chart is both a price and a time chart. The vertical axis shows a scale representing the price of the contract. The horizontal axis records the passage of time. Dates are marked along the bottom of the chart. All the user has to do is plot a vertical bar in the appropriate day, from the day's high to the day's low, called the range. Place a horizontal tick to the right of the vertical bar, identifying the daily closing price. See Figure 3.7. The reason for placing the tick to the right of the bar is to distinguish it from the opening price, which chartists record to the left of the bar. Once that day's activity has been plotted, the user moves one day to the right to plot the next day's action. Most chart services use five-day weeks. Weekends are not shown on the chart. Whenever an exchange is closed during the trading week, that day's space is left blank. The bars along the bottom of the chart measure volume. See Figure 3.7. Volume. Another piece of important information should be included on the bar chart. Volume. Volume represents the total amount of trading activity in that market for that day. It is the total number of futures contracts traded during the day, or the number of common stock shares that change hands on a given day in the stock market. The volume is recorded by a vertical bar at the bottom of the chart, under that day's price bar. A higher volume bar means the volume was heavier for that day. A smaller bar represents lighter volume. A vertical scale along the bottom of the chart is provided to help plot the data, as shown in Figure 3.7. Future's open interest. Open interest is the total number of outstanding futures contracts that are held by market participants at the end of the day. Open interest is the number of outstanding contracts held by the longs or the shorts, not the total of both. Remember, because we're dealing with futures contracts, for every long there must also be a short. Therefore, we only have to know the totals on one side. Open interest is marked on the chart, with a solid line along the bottom, usually just above the volume but below the price. See Figure 3.8. Total vs. Individual Volume and Open Interest Numbers in Futures. Futures chart services, along with most futures technicians, use only the total volume and open interest figures. Although figures are available for each individual delivery month, the total figures for each commodity market are the ones that are used for forecasting purposes. There is a good reason for this. In the early stages of a futures contract's life, volume and open interest are usually quite small. The figures build up as the contract reaches maturity. In the last couple of months before expiration, however, the numbers begin to drop again. Obviously, traders have to liquidate open positions as the contract approaches expiration. Therefore, the increase in the numbers in the first few months of life and the decline near the end of trading have nothing to do with market direction and are just a function of the limited life feature of a commodity futures contract. To provide the necessary continuity in volume and open interest numbers and to give them forecasting value, the total numbers are generally used. Stock charts plot total volume figures, but do not include open interest. Volume and open interest reported a day late in futures. Futures volume and open interest numbers are reported a day late. Therefore, the chartist must be content with a day's lag in obtaining and interpreting the figures. The numbers are usually reported during the following day's trading hours, but too late for publication in the day's financial newspapers. Estimated volume figures are available, however, after the markets close and are included in the following morning's paper. Estimated volume numbers are just that, but they do at least give the dot futures technician some idea of whether trading activity was heavier or lighter the previous day. In the morning paper, therefore, what the reader gets is the last day's futures prices along with an estimated volume figure. Official volume and open interest numbers, however, are given for the day before. Stock chartists don't have that problem. Volume totals for stocks are immediately available. The value of individual volume and open interest numbers in futures. The individual open interest numbers in futures do provide valuable information. They tell us which contracts are the most liquid for trading purposes. As a general rule, trading activity should be limited to those delivery months with the highest open interest. Months with low open interest numbers should be avoided. As the term implies, higher open interest means that there is more interest in certain delivery months. Weekly and Monthly Bar Charts We've focused so far on the daily bar chart, however, be aware that a bar chart can be constructed for any time period. The intraday bar chart measures the high, low, and last prices for periods as short as five minutes. The average daily bar chart covers from six to nine months of price action. For longer range trend analysis, however, weekly and monthly bar charts must be used. The value of using these longer range charts is covered in Chapter 8. But the method of constructing and updating the charts is essentially the same. See figures 3.9 and 3.10. On the weekly chart, one bar represents the price activity for the entire week. On the monthly chart, each bar shows the entire month's price action. Obviously, weekly and monthly charts compress the price action to allow for much longer range trend analysis. A weekly chart can go back as much as five years, and a monthly chart up to 20 years. It's a simple technique that helps the chartists study the markets from a longer range perspective. A valuable perspective that is often lost by relying solely on daily charts. Conclusion Now that we know how to plot a bar chart, and having introduced the three basic sources of information: price, volume, and open interest, we're ready to look at how that data is interpreted. Remember that the chart only records the data. In itself, it has little value. It's much like a paintbrush and canvas. By themselves, they have no value. In the hands of a talented artist, however, they can help create beautiful images. Perhaps an even better comparison is a scalpel. In the hands of a gifted surgeon, it can help save lives. In the hands of most of us, however, a scalpel is not only useless, but might even be dangerous. A chart can become an extremely useful tool in the art or skill of market forecasting, once the rules are understood. Let's begin the process. In the next chapter, we'll look at some of the basic concepts of trend, and what I consider to be the building blocks of chart analysis. End of chapter 3. Chapter 4. Basic Concepts of Trend Definition of Trend Definition of Trend The concept of trend is absolutely essential to the technical approach to market analysis. All of the tools used by the chartists, support and resistance levels, price patterns, moving averages, trend lines, etc. have the sole purpose of helping to measure the trend of the market for the purpose of participating in that trend. So let's spend a little time to define what a trend is and classify it into a few categories. In a general sense, the trend is simply the direction of the market, which way it's moving. But we need a more precise definition with which to work. First of all, markets don't generally move in a straight line in any direction. Market moves are characterized by a series of zigzags. These zigzags resemble a series of successive waves, with fairly obvious peaks and troughs. It is the direction of those peaks and troughs that constitutes market trend. Whether those peaks and troughs are moving up, down, or sideways, tells us the trend of the market. An uptrend would be defined as a series of successively higher peaks and troughs. A downtrend is just the opposite, a series of declining peaks and troughs. Horizontal peaks and troughs would identify a sideways price trend. See figures 4.1 AD. Trend has three directions. We've mentioned an uptrend, downtrend, and sideways trend, for a very good reason. Most people tend to think of markets as being always in either an uptrend or a downtrend. The fact of the matter is, that markets actually move in three directions. Up, down, and sideways. It is important to be aware of this distinction, because for at least a third of the time, by a conservative estimate, prices move in a flat, horizontal pattern that is referred to as a trading range. This type of sideways action reflects a period of equilibrium in the price level, where the forces of supply and demand are in a state of relative balance. If you'll recall, Dow theory refers to this type of pattern as a line. Although we've defined a flat market as having a sideways trend, it is more commonly referred to as being trendless. Most technical tools and systems are trend-following in nature, which means that they are primarily designed for markets that are moving up or down. They usually work very poorly, or not at all, when markets enter these lateral or trendless phases. It is during these periods of sideways market movement that technical traders experience their greatest frustration, and systems traders their greatest equity losses. The trend-following system, by its very definition, needs a trend in order to do its stuff. The failure here lies not with the system, rather, the failure lies with the trader who is attempting to apply a system designed for trending markets into a non-trending market environment. There are three decisions confronting the trader. Whether to buy a market, go long, sell a market, go short, or do nothing, stand aside. When a market is rising, the buying strategy is preferable. When it is falling, the second approach would be correct. However, when the market is moving sideways, the third choice to stay out of the market is usually the wisest. Trend has three classifications. In addition to having three directions, trend is usually broken down into the three categories mentioned in the previous chapter. Those three categories are the major, intermediate, and near-term trends. In reality, there are almost an infinite number of trends interacting with one another. From the very short-term trends covering minutes and hours, to super-long trends lasting 50 or 100 years. Most technicians, however, limit trend classifications to three. There is a certain amount of ambiguity, however, as to how different analysts define each trend. Dow theory, for example, classifies the major trend as being in effect for longer than a year. Because futures traders operate in a shorter time dimension than do stock investors, I would be inclined to shorten the major trend to anything over six months in the commodity markets. Dow defined the intermediate, or secondary, trend as three weeks to as many months, which also appears about right for the futures markets. The near-term trend is usually defined as anything less than two or three weeks. Each trend becomes a portion of its next larger trend. For example, the intermediate trend would be a correction in the major trend. In a long-term uptrend, the market pauses to correct itself for a couple of months before resuming its upward path. That secondary correction would itself consist of shorter waves that would be identified as near-term dips and rallies. This theme recurs many times that each trend is part of the next larger trend and is itself comprised of smaller trends. See figures 4.2a and b. In figure 4.2a, the major trend is up, as reflected by the rising peaks and troughs, points 1, 2, 3, 4. The corrective phase, 2-3, represents an intermediate correction within the major uptrend. But notice that the wave 2-3 also breaks down into three smaller waves, A, B, C. At point C, the analyst would say that the major trend was still up, but the intermediate and near-term trends were down. At point 4, all three trends would be up. It is important to understand the distinction between the various degrees of trend. When someone asks what the trend is in a given market, it is difficult, if not impossible, to respond until you know which trend the person is inquiring about. You may have to respond in the manner previously discussed by defining the three different trend classifications. Quite a bit of misunderstanding arises because of different traders' perceptions as to what is meant by a trend. To long-term position traders, a few days to a few weeks price action might be insignificant. To a day trader, a two- or three-day advance might constitute a major uptrend. It is especially important, then, to understand the different degrees of trend and to make sure that all involved in a transaction are talking about the same ones. As a general statement, most trend-following approaches focus on the intermediate trend, which may last for several months. The near-term trend is used primarily for timing purposes. In an intermediate uptrend, short-term setbacks would be used to initiate long positions. Support and resistance In the previous discussion of trend, it was stated that prices move in a series of peaks and troughs, and that the direction of those peaks and troughs determine the trend of the market. Let's now give those peaks and troughs their appropriate names, and, at the same time, introduce the concepts of support and resistance. The troughs, or "reaction lows", are called "support". The term is self-explanatory, and indicates that support is a level or area on the chart under the market where buying interest is sufficiently strong to overcome selling pressure. As a result, a decline is halted and prices turn back up again. Usually a support level is identified beforehand by a previous reaction low. In figure 4.3a, points 2 and 4 represent support levels in an uptrend. See figures 4.3a and b. Resistance is the opposite of support, and represents a price level or area over the market where selling pressure overcomes buying pressure, and a price advance is turned back. Usually a resistance level is identified by a previous peak. In figure 4.3a, points 1 and 3 are resistance levels. Figure 4.3a shows an uptrend. In an uptrend, the support and resistance levels show an ascending pattern. Figure 4.3b shows a downtrend with descending peaks and troughs. In the downtrend, points 1 and 3 are support levels under the market, and points 2 and 4 are resistance levels over the market. In an uptrend, the resistance levels represent pauses in that uptrend, and are usually exceeded at some point. In a downtrend, support levels are not sufficient to stop the decline permanently, but are able to check it at least temporarily. A solid grasp of the concepts of support and resistance is necessary for a full understanding of the concept of trend. For an uptrend to continue, each successive low support level must be higher than the one preceding it. Each rally high, resistance level, must be higher than the one before it. If the corrective dip in an uptrend comes all the way down to the previous lows, it may be an early warning that the uptrend is ending, or at least moving from an uptrend to a sideways trend. If the support level is violated, then a trend reversal from up to down is likely. Each time a previous resistance peak is being tested, the uptrend is in an especially critical phase. Failure to exceed a previous peak in an uptrend, or the ability of prices to bounce off the previous support low in a downtrend, is usually the first warning that the existing trend is changing. Chapters 5 and 6 on price patterns show how the testing of these support and resistance levels form pictures on the charts that suggest either a trend reversal in progress or merely a pause in the existing trend. But the basic building blocks on which those price patterns are based are support and resistance levels. Figures 4.4a to c are examples of a classic trend reversal. Notice, in figure 4.4a, that at .5 prices failed to exceed the previous peak, .3, before turning down to violate the previous low at .4. This trend reversal could have been identified simply by watching the support and resistance levels. In our coverage of price patterns, this type of reversal pattern will be identified as a double top. How Support and Resistance Levels Reverse Their Roles So far we've defined support as a previous low and resistance as a previous high. However, this is not always the case. This leads us to one of the more interesting and lesser known aspects of support and resistance: their reversal of roles. Whenever a support or resistance level is penetrated by a significant amount, they reverse their roles and become the opposite. In other words, a resistance level becomes a support level, and support becomes resistance. To understand why this occurs, perhaps it would be helpful to discuss some of the psychology behind the creation of support and resistance levels. The Psychology of Support and Resistance To illustrate, let's divide the market participants into three categories: the longs, the shorts, and the uncommitted. The longs are those traders who have already purchased contracts; the shorts are those who have already committed themselves to the sell side; the uncommitted are those who have either gotten out of the market or remain undecided as to which side to enter. Let's assume that a market starts to move higher from a support area where prices have been fluctuating for some time. The longs, those who bought near the support area, are delighted, but regret not having bought more. If the market would dip back near that support area again, they could add to their long positions. The shorts now realize, or strongly suspect, that they are on the wrong side of the market. How far the market has moved away from that support area will greatly influence these decisions. But we'll come back to that point a bit later. The shorts are hoping, and praying, for a dip back to that area where they went short, so they can get out of the market where they got in, their break-even point. Those sitting on the sidelines can be divided into two groups: those who never had a position, and those who, for one reason or another, liquidated previously held long positions in the support area. The latter group are, of course, mad at themselves for liquidating their longs prematurely, and are hoping for another chance to reinstate those longs near where they sold them. The final group, the undecided, now realize that prices are going higher, and resolve to enter the market on the long side on the next good buying opportunity. All four groups are resolved to "buy the next dip." They all have a vested interest in that support area under the market. Naturally, if prices do decline near that support, renewed buying by all four groups will materialize to push prices up. The more trading that takes place in that support area, the more significant it becomes, because more participants have a vested interest in that area. The amount of trading in a given support or resistance area can be determined in three ways: The amount of time spent there, volume, and how recently the trading took place. The longer the period of time that prices trade in a support or resistance area, the more significant that area becomes. For example, if prices trade sideways for three weeks in a congestion area before moving higher, that support area would be more important than if only three days of trading had occurred. Volume is another way to measure the significance of support and resistance. If a support level is formed on heavy volume, this would indicate that a large number of units changed hands and would mark that support level as more important than if very little trading had taken place. Point and figure charts that measure the intraday trading activity are especially useful in identifying these price levels where most of the trading took place and, consequently, where support and resistance will be most likely to function. A third way to determine the significance of a support or resistance area is how recently the trading took place. Because we are dealing with the reaction of traders to market movement and to positions that they have already taken or failed to take, it stands to reason that the more recent the activity, the more potent it becomes. Now let's turn the tables and imagine that, instead of moving higher, prices move lower. In the previous example, because prices advanced, the combined reaction of the market participants caused each downside reaction to be met with additional buying, thereby creating new support. However, if prices start to drop and move below the previous support area, the reaction becomes just the opposite. All those who bought in the support area now realize that they made a mistake. For futures traders, their brokers are now calling frantically for more margin money. Because of the highly leveraged nature of futures trading, traders cannot sit with losses very long. They must put up additional margin money or liquidate their losing positions. What created the previous support in the first place was the predominance of buy orders under the market. Now, however, all of the previous buy orders under the market have become sell orders over the market. Support has become resistance. And the more significant that previous support area was, that is, the more recent, and the more trading that took place there, the more potent it now becomes as a resistance area. All of the factors that created support by the three categories of participants, the longs, the shorts, and the uncommitted, will now function to put a ceiling over prices on subsequent rallies or bounces. It is useful once in a while to pause and reflect on why the price patterns used by chartists, and concepts like support and resistance, actually do work. It's not because of some magic produced by the charts, or some lines drawn on those charts. These patterns work because they provide pictures of what the market participants are actually doing, and enable us to determine their reactions to market events. Chart analysis is actually a study of human psychology and the reactions of traders to changing market conditions. Unfortunately, because we live in the fast-paced world of financial markets, we tend to rely heavily on chart terminology and shortcut expressions that overlook the underlying forces that created the pictures on the charts in the first place. There are sound psychological reasons why support and resistance levels can be identified on price charts, and why they can be used to help predict market movements. Support becoming resistance, and vice versa. Degree of penetration A support level, penetrated by a significant margin, becomes a resistance level, and vice versa. Figures 4.5 A to C are similar to figures 4.3 A and B, but with one added refinement. Now, notice that as prices are rising in figure 4.5 A, the reaction at 0.4 stops at or above the top of the peak at 0.1. That previous peak at 0.1 had been a resistance level, but once it was decisively penetrated by wave 3, that previous resistance peak became a support level. All of the previous selling near the top of wave 1, creating the resistance level, has now become buying under the market. In figure 4, 0.5 B, showing declining prices, 0.1, which had been a previous support level under the market, has now become a resistance level over the market acting as a ceiling at 0.4. It was mentioned earlier that the distance prices traveled away from support or resistance increased the significance of that support or resistance. This is particularly true when support and resistance levels are penetrated and reverse rolls. For example, it was stated that support and resistance levels reverse rolls only after a significant penetration, but what constitutes significant? There is quite a bit of subjectivity involved here in determining whether a penetration is significant or not. As a benchmark, some chartists use a 3% penetration as a criteria, particularly for major support and resistance levels. Shorter-term support and resistance areas would probably require a much smaller number, like 1%. In reality, each analyst must decide for himself or herself what constitutes a significant penetration. It's important to remember, however, that support and resistance areas only reverse roles when the market moves far enough away to convince the market participants that they have made a mistake. The farther away the market moves, the more convinced they become. The Importance of Round Numbers as Support and Resistance There is a tendency for round numbers to stop advances or declines. Traders tend to think in terms of important round numbers, such as 10, 20, 25, 50, 75, 100, and multiples of 1,000, as price objectives and act accordingly. These round numbers, therefore, will often act as psychological support or resistance levels. A trader can use this information to begin taking profits as an important round number is approached. The gold market is an excellent example of this phenomenon. The 1982 bear market low was right at $300. The market then rallied to just above $500 in the first quarter of 1983, before falling to $400. A gold rally in 1987 stopped at $500 again. From 1990 to 1997, gold failed each attempt to break through $400. The Dow Jones Industrial Average has shown a tendency to stall at multiples of 1,000. One trading application of this principle is to avoid placing trading orders right at these obvious round numbers. For example, if the trader is trying to buy into a short-term market dip in an uptrend, it would make sense to place limit orders just above an important round number. Because others are trying to buy the market at the round number, the market may never get there. Traders looking to sell on a bounce should place resting sell orders just below round numbers. The opposite would be true when placing protective stops on existing positions. As a general rule, avoid placing protective stops at obvious round numbers. In other words, protective stops on long positions should be placed below round numbers and on short positions, above such numbers. The tendency for markets to respect round numbers, and especially the more important round numbers previously referred to, is one of those peculiar market characteristics that can prove most helpful in trading and should be kept in mind by the technically oriented trader. Trendlines Now that we understand support and resistance, let's add another building block to our arsenal of technical tools. The trendline, see figures 4.6A to C. The basic trendline is one of the simplest of the technical tools employed by the chartist, but is also one of the most valuable. An uptrendline is a straight line drawn upward to the right, along successive reaction lows, as shown by the solid line in figure 4.6A. A downtrendline is drawn downward to the right, along successive rally peaks, as shown in figure 4.6B. Drawing a trendline The correct drawing of trendlines is a lot like every other aspect of charting, and some experimenting with different lines is usually necessary to find the correct one. Sometimes a trendline that looks correct may have to be redrawn, but there are some useful guidelines in the search for that correct line. First of all, there must be evidence of a trend. This means that, for an uptrendline to be drawn, there must be at least two reaction lows, with the second low higher than the first. Of course, it always takes two points to draw any straight line. In figure 4.6A, for example, only after prices have begun to move higher from point 3 is the chartist reasonably confident that a reaction low has been formed, and only then can a tentative uptrendline be drawn under points 1 and 3. Some chartists require that the peak at point 2 be penetrated to confirm the uptrend before drawing the trendline. Others only require a 50% retracement of wave 2 to 3, or that prices approach the top of wave 2. While the criteria may differ, the main point to remember is that the chartist wants to be reasonably sure that a reaction low has been formed before identifying a valid reaction low. Once two ascending lows have been identified, a straight line is drawn connecting the lows and projected up and to the right. Tentative vs. the valid trendline So far, all we have is a tentative trendline. In order to confirm the validity of a trendline, however, that line should be touched a third time, with prices bouncing off of it. Therefore, in figure 4.6A, the successful test of the uptrendline at point 5 confirmed the validity of that line. Figure 4.6B shows a downtrend, but the rules are the same. The successful test of the trendline occurs at point 5. To summarize, two points are needed to draw the trendline, and a third point to make it a valid trendline. How to use the trendline Once the third point has been confirmed, and the trend proceeds in its original direction, that trendline becomes very useful in a variety of ways. One of the basic concepts of trend is that a trend in motion will tend to remain in motion. As a corollary to that, once a trend assumes a certain slope or rate of speed, as identified by the trendline, it will usually maintain the same slope. The trendline then helps not only to determine the extremities of the corrective phases, but maybe even more importantly, tells us when that trend is changing. In an uptrend, for example, the inevitable corrective dip will often touch or come very close to the uptrendline. Because the intent of the trader is to buy dips in an uptrend, that trendline provides a support boundary under the market that can be used as a buying area. A down trendline can be used as a resistance area for selling purposes, see figures 4.7a and b. As long as the trendline is not violated, it can be used to determine buying and selling areas. However, at point 9 in figures 4.7ab, the violation of the trendline signals a trend change, calling for liquidation of all positions in the direction of the previous trend. Very often, the breaking of the trendline is one of the best early warnings of a change in trend. How to determine the significance of a trendline? Let's discuss some of the refinements of the trendline. First, what determines the significance of a trendline? The answer to that question is twofold: the longer it has been intact and the number of times it has been tested. A trendline that has been successfully tested eight times, for example, that has continually demonstrated its validity, is obviously a more significant trendline than one that has only been touched three times. Also, a trendline that has been in effect for nine months is of more importance than one that has been in effect for nine weeks or nine days. The more significant the trendline, the more confidence it inspires, and the more important is its penetration. Trendlines should include all price action. Trendlines on bar charts should be drawn over or under the entire day's price range. Some chartists prefer to draw the trendline by connecting only the closing prices, but that is not the more standard procedure. The closing price may very well be the most important price of the day, but it still represents only a small sample of that day's activity. The technique of including the day's price range takes into account all of the activity and is the more common usage. See Figure 4.8. How to handle small trendline penetrations. Sometimes prices will violate a trendline on an intraday basis, but then close in the direction of the original trend, leaving the analyst in some doubt as to whether or not the trendline has actually been broken. See Figure 4.9. Figure 4.9 shows how such a situation might look. Prices did dip under the trendline during the day, but closed back above the up trendline. Should the trendline be redrawn? Unfortunately, there's no hard and fast rule to follow in such a situation. Sometimes it is best to ignore the minor breach, especially if subsequent market action proves that the original line is still valid. What constitutes a valid breaking of a trendline? As a general rule, a close beyond the trendline is more significant than just an intraday penetration. To go a step further, sometimes even a closing penetration is not enough. Most technicians employ a variety of time and price filters in an attempt to isolate valid trendline penetrations and eliminate bad signals or whipsaws. One example of a price filter is the 3% penetration criteria. This price filter is used mainly for the breaking of longer-term trendlines, but requires that the trendline be broken, on a closing basis, by at least 3%. The 3% rule doesn't apply to some financial futures, such as the interest rate markets. If, for example, gold prices broke a major up trendline at $400, prices would have to close below that line by 3% of the price level where the line was broken. In this case, prices would have to close $12 below the trendline, or at $388. The price filter is useless. Obviously, a $12 penetration criteria would not be appropriate for shorter-term trading. Perhaps a 1% criterion would serve better in such cases. The percent rule represents just one type of price filter. Stock chartists, for example, might require a full point penetration and ignore fractional moves. There is trade-off involved in the use of any type of filter. If the filter is too small, it won't be very useful in reducing the impact of whipsaws. If it's too big, then much of the initial move will be missed before a valid signal is given. Here again, the trader must determine what type of filter is best suited to the degree of trend being followed, always making allowances for the differences in the individual's markets. An alternative to a price filter requiring that a trendline be broken by some predetermined price increment or percentage amount is a time filter. The common time filter is the two-day rule. In other words, to have a valid breaking of a trendline, prices must close beyond the trendline for two successive days. To break an up-trendline, therefore, prices must close under the trendline two days in a row. A one-day violation would not count. The 1-3% rule and the two-day rule are also applied to the breaking of important support and resistance levels, not just to major trendlines. Another filter would require a Friday close beyond a major breakout point to ensure a weekly signal. How Trendlines Reverse Rolls It was mentioned earlier that support and resistance levels became the opposite once violated. The same principle holds true of trendlines. See figures 4.10 AC. In other words, an up-trendline, a support line, will usually become a resistance line once it's decisively broken. A down-trendline, a resistance line, will often become a support line once it's decisively broken. This is why it's usually a good idea to project all trendlines as far out to the right on the chart as possible, even after they've been broken. It's surprising how often old trendlines act as support and resistance lines again in the future, but in the opposite role. Measuring implications of trendlines Trendlines can be used to help determine price objectives. We'll have a lot more to say about price objectives in the next two chapters on price patterns. In fact, some of the price objectives addressed that are derived from various price patterns are similar to the one we'll cover here with trendlines. Stated briefly, once a trendline is broken, prices will usually move a distance beyond the trendline, equal to the vertical distance that prices achieved on the other side of the line, prior to the trend reversal. In other words, if in the prior uptrend, prices moved $50 above the uptrendline, measured vertically, then prices would be expected to drop that same $50 below the trendline after it's broken. In the next chapter, for example, we'll see that this measuring rule using the trendline is similar to that used for the well-known head and shoulders reversal pattern, where the distance from the head to the neckline is projected beyond that line once it's broken. The FAN Principle This brings us to another interesting use of the trendline, the FAN Principle. See figures 4.11a to C. Sometimes after the violation of an uptrendline, prices will decline a bit before rallying back to the bottom of the old uptrendline, now a resistance line. In figure 4.11a, notice how prices rallied to but failed to penetrate line 1. A second trendline, line 2, can now be drawn, which is also broken. Now, after another failed rally attempt, a third line is drawn, line 3. The breaking of that third trendline is usually an indication that prices are headed lower. In figure 4.11b, the breaking of the third down trendline, line 3, constitutes a new uptrend signal. Notice in these examples how previously broken support lines became resistance, and resistance lines became support. The term FAN Principle derives from the appearance of the lines that gradually flatten out, resembling a fan. The important point to remember here is that the breaking of the third line is the valid trend reversal signal. The importance of the number 3. In examining the three lines in the FAN Principle, it's interesting to note how often the number 3 shows up in the study of technical analysis and the important role it plays in so many technical approaches. For example, the FAN Principle uses three lines. Major bull and bear markets usually have three major phases, Dow theory and Elliott Wave theory. There are three kinds of gaps, to be covered shortly. Some of the more commonly known reversal patterns, such as the triple top and the head and shoulders, have three prominent peaks. There are three different classifications of trend, major, secondary and minor, and three trend directions, up, down and sideways. Among the generally accepted continuation patterns there are three types of triangles, the symmetrical, ascending, and descending. For whatever the reason, the number 3 plays a very prominent role throughout the entire field of technical analysis. The relative steepness of the trend line The relative steepness of the trend line is also important. In general, most important uptrend lines tend to approximate an average slope of 45 degrees. Some chartists simply draw a 45 degree line on the chart from a prominent high or low, and use this as a major trend line. The 45 degree line was one of the techniques favored by W.D. Gann. Such a line reflects a situation where prices are advancing or declining, at such a rate, that price and time are in perfect balance. If a trend line is too steep, see line 1 in figure 4.12, it usually indicates that prices are advancing too rapidly, and that the current steep ascent will not be sustained. The breaking of that steep trend line may be just a reaction back to a more sustainable slope, closer to the 45 degree line, line 2. If a trend line is too flat, see line 3, it may indicate that the uptrend is too weak and not to be trusted. How to adjust trend lines Sometimes trend lines have to be adjusted to fit a slowing or an accelerating trend. See figure 4.13 and figures 4.14, A and B. For example, as shown in the previous case, if a steep trend line is broken, a slower trend line might have to be drawn. If the original trend line is too flat, it may have to be redrawn at a steeper angle. Figure 4.13 shows a situation where the breaking of the steeper trend line, line 1, necessitated the drawing of a slower line, line 2. In figure 4.14, A, the original trend line, line 1, is too flat and has to be redrawn at a steeper angle, line 2. The uptrend accelerated, requiring a steeper line. A trend line that is too far away from the price action is obviously of little use in tracking the trend. In the case of an accelerating trend, sometimes several trend lines may have to be drawn at increasingly steeper angles. In my experience, however, where steeper trend lines become necessary, it is best to resort to another tool, the moving average, which is the same as a curvilinear trend line. One of the advantages of having access to several different types of technical indicators is being able to choose the one most appropriate for a given situation. All of the techniques covered in this book work well in certain situations, but not so well in others. By having an arsenal of tools to fall back on, the technician can quickly switch from one tool to another that might work better in a given situation. An accelerated trend is one of those cases where a moving average would be more useful than a series of steeper and steeper trend lines. Just as there are several different degrees of trend in effect at any one time, so is there a need for different trend lines to measure those various trends. A major uptrend line, for example, would connect the low points of the major uptrend, while a shorter and more sensitive line might be used for secondary swings. An even shorter line can measure the short-term movements. See figure 4.15. The channel line. The channel line, or the return line as it is sometimes called, is another useful variation of the trend line technique. Sometimes prices trend between two parallel lines, the basic trend line and the channel line. Obviously, when this is the case, and when the analyst recognizes that a channel exists, this knowledge can be used to profitable advantage. The drawing of the channel line is relatively simple. In an uptrend, see figure 4.16a, first draw the basic uptrend line along the lows, then draw a dotted line from the first prominent peak, 0.2, which is parallel to the basic uptrend line. Both lines move up to the right, forming a channel. If the next rally reaches and backs off from the channel line, at 0.4, then a channel may exist. If prices then drop back to the original trend line, at 0.5, then a channel probably does exist. The same holds true for a downtrend, figure 4.16b, but of course in the opposite direction. The reader should immediately see the value of such a situation. The basic uptrend line can be used for the initiation of new long positions. The channel line can be used for short-term profit-taking. More aggressive traders might even use the channel line to initiate a counter-trend short position, although trading in the opposite direction of the prevailing trend can be a dangerous and usually costly tactic. As in the case of the basic trend line, the longer the channel remains intact and the more often it is successfully tested, the more important and reliable it becomes. The breaking of the major trend line indicates an important change in trend. But the breaking of a rising channel line has exactly the opposite meaning and signals an acceleration of the existing trend. Some traders view the clearing of the upper line in an uptrend as a reason to add to long positions. Another way to use the channel technique is to spot failures to reach the channel line, usually a sign of a weakening trend. In figure 4.17, the failure of prices to reach the top of the channel at .5 may be an early warning that the trend is turning and increases the odds that the other line, the basic uptrend line, will be broken. As a general rule of thumb, the failure of any move within an established price channel to reach one side of the channel usually indicates that the trend is shifting and increases the likelihood that the other side of the channel will be broken. The channel can also be used to adjust the basic trend line, see figures 4.18 and 4.19. If prices move above a projected rising channel line by a significant amount, it usually indicates a strengthening trend. Some chartists then draw a steeper basic uptrend line from the last reaction low parallel to the new channel line, as demonstrated in figure 4.18. Often, the new steeper support line functions better than the old flatter line. Similarly, the failure of an uptrend to reach the upper end of a channel justifies the drawing of a new support line under the last reaction low parallel to the new resistance line over the past two peaks, as shown in figure 4.19. Channel lines have measuring implications. Once a breakout occurs from an existing price channel, prices usually travel a distance equal to the width of the channel. Therefore, the user has to simply measure the width of the channel and then project that amount from the point at which either trend line is broken. It should always be kept in mind, however, that of the two lines, the basic trend line is by far the more important and the more reliable. The channel line is a secondary use of the trend line technique, but the use of the channel line works often enough to justify its inclusion in the chartist toolkit. Percentage Retracements In all of the previous examples of uptrends and downtrends, the reader has no doubt noticed that after a particular market move, prices retrace a portion of the previous trend before resuming the move in the original direction. These counter trend moves tend to fall into certain predictable percentage parameters. The best known application of the phenomenon is the 50% retracement, let's say. Let's say for example that a market is trending higher and travels from the 100 level to the 200 level. Very often, the subsequent reaction retraces about half of the prior move to about the 150 level before upward momentum is regained. This is a very well-known market tendency and happens quite frequently. Also, these percentage retracements apply to any degree of trend: major, secondary, and near-term. Besides the 50% retracement, there are minimum and maximum percentage parameters that are also widely recognized: the one-third and the two-thirds retracements. In other words, the price trend can be divided into thirds. Usually, a minimum retracement is about 33% and a maximum about 66%. What this means is that, in a correction of a strong trend, the market usually retraces at least a third of the previous move. This is very useful information for a number of reasons. If a trader is looking for a buying area under the market, he or she can just compute a 33-50% zone on the chart and use that price zone as a general frame of reference for buying opportunities. The C figures 4.20 A and B. The maximum retracement parameter is 66%, which becomes an especially critical area. If the prior trend is to be maintained, the correction must stop at the two-thirds point. This then becomes a relatively low-risk buying area in an uptrend or selling area in a downtrend. If prices move beyond the two-thirds point, the odds then favor a trend reversal rather than just a retracement. The move usually then retraces the entire 100% of the prior trend. You may have noticed that the three percentage retracement parameters we've mentioned so far, 50%, 33%, and 66%, are taken right from the original Dow theory. When we get to the Elliott Wave theory and Fibonacci ratios, we will see that followers of that approach use percentage retracements of 38% and 62%. I prefer to combine both approaches for a minimum retracement zone of 33-38% and a maximum zone of 62-66%. Some technicians round off these numbers even further to arrive at a 40 to 60% retracement zone. Students of W.D. Gann are aware that he broke down the trend structure into eighths, V8, 2-eighths, 3-eighths, 4-eighths, 5-eighths, 6-eighths, 7-eighths, 8-eighths. However, even Gann attached special importance to the 3-eighths, 38%, 4-eighths, 50%, and 5-eighths, 62% retracement numbers, and also felt it was important to divide the trend into thirds, 1-third, 33%, and 2-thirds, 66%. Speed Resistance Lines Speaking of thirds, let's touch on another technique that combines the trend line with percentage retracement speed lines. This technique, developed by Edson Gould, is actually an adaptation of the idea of dividing the trend into thirds. The main difference from the percentage retracement concept is that the speed resistance lines, or speed lines, measure the rate of ascent or descent of a trend, in other words, its speed. To construct a bullish speed line, find the highest point in the current uptrend. See figure 4.21a. From that high point on the chart, a vertical line is drawn toward the bottom of the chart to where the trend began. That vertical line is then divided into thirds. A trend line is then drawn from the beginning of the trend, through the two points marked off on the vertical line, representing the 1/3 and 2/3 points. In a downtrend, just reverse the process. Measure the vertical distance from the low point in the downtrend to the beginning of the trend, and draw two lines from the beginning of the trend, through the 1/3 and 2/3 points on the vertical line. See figures 4.21a and b. Each time a new high is set in an uptrend or a new low and a downtrend, a new set of lines must be drawn, because there is now a new high or low point. Because the speed lines are drawn from the beginning of the trend, to the 1/3 and 2/3 points, those trend lines may sometimes move through some of the price action. This is one case where trend lines are not drawn under lows or over highs, but actually through the price action. If an uptrend is in the process of correcting itself, the downside correction will usually stop at the higher speed line, the 2/3 speed line. If not, prices will drop to the lower speed line, the V3 speed line. If the lower line is also broken, prices will probably continue all the way to the beginning of the prior trend. In a downtrend, the breaking of the lower line indicates a probable rally to the higher line. If that is broken, a rally to the top of the prior trend would be indicated. As with all trend lines, speed lines reverse roles once they are broken. Therefore, during the correction of an uptrend, if the upper line, 2/3 line, is broken and prices fall to the 1/3 line and rally from there, that upper line becomes a resistance barrier. Only when that upper line is broken would a signal be given that the old highs will probably be challenged. The same principle holds true in downtrends. GAN and Fibonacci fan lines Charting software also allows the drawing of GAN and Fibonacci fan lines. Fibonacci fan lines are drawn in the same fashion as the speed line, except that Fibonacci lines are drawn at 38% and 62% angles. We'll explain where those 38% and 62% numbers come from in Chapter 13, Elliott Wave Theory. GAN lines, named after the legendary commodity trader WD GAN, are trend lines drawn from prominent tops or bottoms at specific geometric angles. The most important GAN line is drawn at a 45 degree angle from a peak or trough. Steeper GAN lines can be drawn during an uptrend at 633/4 degree and 75 degree angles. Flatter GAN lines can be drawn at 2, 6, V4 and 15 degree lines. It's possible to draw as many as 9 different GAN lines. Again, GAN and Fibonacci lines are used in the same way as speed lines. They are supposed to provide support during downward corrections. When one line is broken, prices will usually fall to the next lower line. GAN lines are somewhat controversial. Even if one of them works, you can't be sure in advance which one it will be. Some chartists question the validity of drawing geometric trend lines at all. Internal Trend Lines These are variations of the trend line that don't rely on extreme highs or lows. Instead, internal trend lines are drawn through the price action and connect as many internal peaks or troughs as possible. Some chartists develop a good eye for this type of trend line and find them useful. The problem with internal trend lines is that their drawing is very subjective, whereas the rules for drawing of more traditional trend lines along the extreme highs and lows are more exact. See figure 4.21c. Reversal Days Another important building block is the reversal day. This particular chart formation goes by many names. The top reversal day, the bottom reversal day, the buying or selling climax, and the key reversal day. By itself, this formation is not of major importance. But, taken in the context of other technical information, it can sometimes be significant. Let's first define what a reversal day is. A reversal day takes place either at a top or a bottom. The generally accepted definition of a top reversal day is the setting of a new high in an uptrend, followed by a lower close on the same day. In other words, prices set a new high for a given up move at some point during the day, usually at or near the opening, then weaken and actually close lower than the previous day's closing. A bottom reversal day would be a new low during the day, followed by a higher close. The wider the range for the day and the heavier the volume, the more significant is the signal for a possible near-term trend reversal. Figures 4.22 AB show what both would look like on a bar chart. Note the heavier volume on the reversal day. Also notice that both the high and low on the reversal day exceed the range of the previous day, forming an outside day. While an outside day is not a requirement for a reversal day, it does carry more significance. See figure 4.22C. The bottom reversal day is sometimes referred to as a "selling climax". This is usually a dramatic turnaround at the bottom of a down move, where all the discouraged longs have finally been forced out of the market on heavy volume. The subsequent absence of selling pressure creates a vacuum over the market, which prices quickly rally to fill. The selling climax is one of the more dramatic examples of the reversal day. And, while it may not mark the final bottom of a falling market, it usually signals that a significant low has been seen. Weekly and monthly reversals. This type of reversal pattern shows up on weekly and monthly bar charts, and with much greater significance. On a weekly chart, each bar represents the entire week's range, with the close registered on Friday. An upside weekly reversal, therefore, would occur when the market trades lower during the week, makes a new low for the move, but on Friday closes above the previous Friday's close. Weekly reversals are much more significant than daily reversals, for obvious reasons, and are watched closely by chartists as signaling important turning points. By the same token, monthly reversals are even more important. Price gaps. Price gaps are simply areas on the bar chart where no trading has taken place. In an uptrend, for example, prices open above the highest price of the previous day, leaving a gap or open space on the chart that is not filled during the day. In a downtrend, the day's highest price is below the previous day's low. Upside gaps are signs of market strength, while downside gaps are usually signs of weakness. Gaps. Gaps can appear on long-term weekly and monthly charts, and, when they do, are usually very significant. But they are more commonly seen on daily bar charts. Several myths exist concerning the interpretation of gaps. One of the maxims often heard is that, "Gaps are always filled." This is simply not true. Some should be filled, and others shouldn't. We'll also see that gaps have different forecasting implications depending on which types they are and where they occur. Three types of gaps. There are three general types of gaps: the breakaway, runaway or measuring, and exhaustion gaps. The breakaway gap. This pattern. The breakaway gap usually occurs at the completion of an important price pattern and usually signals the beginning of a significant market move. After a market has completed a major basing pattern, the breaking of resistance often occurs on a breakaway gap. Major breakouts from topping or basing areas are breeding grounds for this type of gap. The breaking of a major trend line, signaling a reversal of trend, might also see a breakaway gap. Breakaway gaps usually occur on heavy volume. More often than not, breakaway gaps are not filled. Prices may return to the upper end of the gap, in the case of a bullish breakout, and may even close a portion of the gap, but some portion of the gap is often left unfilled. As a rule, the heavier the volume after such a gap appears, the less likely it is to be filled. Upside gaps usually act as support areas on subsequent market corrections. It's important that prices not fall below gaps during an uptrend. In all cases, a close below an upward gap is a sign of weakness. See figures 4.23 A and B. The runaway or measuring gap. After the move has been underway for a while, somewhere around the middle of the move, prices will leap forward to form a second type of gap, or a series of gaps, called the runaway gap. This type of gap reveals a situation where the market is moving effortlessly on moderate volume. In an uptrend, it's a sign of market strength. In a downtrend, a sign of weakness. Here again, runaway gaps act as support under the market on subsequent corrections, and are often not filled. As in the case of the breakaway, a close below the runaway gap is a negative sign in an uptrend. This variety of gap is also called a measuring gap because it usually occurs at about the halfway point in a trend. By measuring the distance the trend has already traveled. From the original trend signal or breakout, an estimate of the probable extent of the remaining move can be determined by doubling the amount already achieved. The exhaustion gap. The final type of gap appears near the end of a market move. After all objectives have been achieved, and the other two types of gaps, breakaway and runaway, have been identified, the analyst should begin to expect the exhaustion gap. Near the end of an uptrend, prices leap forward in a last gasp, so to speak. However, that upward leap quickly fades and prices turn lower within a couple of days or within a week. When prices close under that last gap, it is usually a dead giveaway that the exhaustion gap has made its appearance. This is a classic example where falling below a gap in an uptrend has very bearish implications. The island reversal. This takes us to the island reversal pattern. Sometimes after the upward exhaustion gap has formed, prices will trade in a narrow range for a couple of days or a couple of weeks before gapping to the downside. Such a situation leaves the few days of price action looking like an island surrounded by space or water. The exhaustion gap to the upside, followed by a breakaway gap to the downside, completes the island reversal pattern and usually indicates a trend reversal of some magnitude. Of course, the major significance of the reversal depends on where prices are in the general trend structure. See Figure 4.23C Conclusion This chapter introduced introductory technical tools that I consider to be the building blocks of chart analysis, support and resistance, trend lines and channels, percentage retracements, speed resistance lines, reversal days, and gaps. Every technical approach covered in later chapters uses these concepts and tools in one form or another. Armed with a better understanding of these concepts, we're now ready to begin a study of price patterns. End of chapter four. Chapter five. Major reversal patterns. Introduction. So far we've touched on Dow theory, which is the basis of most trend following work being used today. We've examined the basic concepts of trend, such as support, resistance, and trend lines. And we've introduced volume and open interest. We're now ready to take the next step, which is a study of chart patterns. You'll quickly see that these patterns build on the previous concepts. In chapter four, the definition of a trend was given as a series of ascending or descending peaks and troughs. As long as they were ascending, the trend was up. If they were descending, the trend was down. It was stressed, however, that markets also move sideways for a certain portion of the time. It is these periods of sideways market movement that will concern us most in these next two chapters. It would be a mistake to assume that most changes in trend are very abrupt affairs. The fact is that important changes in trend usually require a period of transition. The problem is that these periods of transition do not always signal a trend reversal. Sometimes these sideways periods just indicate a pause or consolidation in the existing trend after which the original trend is resumed. Price patterns. The study of these transition periods and their forecasting implications leads us to the question of price patterns. First of all, what are price patterns? Price patterns are pictures or formations which appear on price charts of stocks or commodities that can be classified into different categories and that have predictive value. Two types of patterns: reversal and continuation. There are two major categories of price patterns: reversal and continuation. As these names imply, reversal patterns indicate that an important reversal in trend is taking place. The continuation patterns, on the other hand, suggest that the market is only pausing for a while, possibly to correct a near-term overbought or oversold condition, after which the existing trend will be resumed. The trick is to distinguish between the two types of patterns as early as possible during the formation of the pattern. In this chapter, we'll be examining the five most commonly used major reversal patterns. The head and shoulders, triple tops and bottoms, double tops and bottoms, spike tops and bottoms, and the rounding pattern. We will examine the price formation itself, how it is formed on the chart, and how it can be identified. We will then look at the other important considerations, the accompanying volume pattern, and measuring implications. Volume plays an important confirming role in all of these price patterns. In times of doubt, and there are lots of those, a study of the volume pattern accompanying the price data can be the deciding factor as to whether or not the pattern can be trusted. Most price patterns also have certain measuring techniques that help the analyst to determine minimum price objectives. While these objectives are only an approximation of the size of the subsequent move, they are helpful in assisting the trader to determine his or her reward to risk ratio. In chapter five, we'll look at a second category of patterns, the continuation variety. There, we will examine triangles, flags, pennants, wedges, and rectangles. These patterns usually reflect pauses in the existing trend, rather than trend reversals, and are usually classified as intermediate and minor as opposed to major. Preliminary Points Common to All Reversal Patterns Before beginning our discussion of the individual major reversal patterns, there are a few preliminary points to be considered that are common to all of these reversal patterns. 1. A prerequisite for any reversal pattern is the existence of a prior trend. 2. The first signal of an impending trend reversal is often the breaking of an important trend line. 3. The larger the pattern, the greater the subsequent move. 4. Time Topping patterns are usually shorter in duration and more volatile than bottoms. 5. Bottoms usually have smaller price ranges and take longer to build. 6. Volume Volume is usually more important on the upside. The need for a prior trend. The existence of a prior major trend is an important prerequisite for any reversal pattern. A market must obviously have something to reverse. A formation occasionally appears on the charts, resembling one of the reversal patterns. If that pattern, however, has not been preceded by a trend, there is nothing to reverse and the pattern is suspect. Knowing where certain patterns are most apt to occur in the trend structure is one of the key elements in pattern recognition. A corollary to this point of having a prior trend to reverse is the matter of measuring implications. It was stated earlier that most of the measuring techniques give only minimum price objectives. The maximum objective would be the total extent of the prior move. If a major bull market has occurred and a major topping pattern is being formed, the maximum implication for the potential move to the downside would be a 100% retracement of the bull market, or the point at which it all began. The breaking of important trend lines. The first sign of an impending trend reversal is often the breaking of an important trend line. Remember, however, that the violation of a major trend line does not necessarily signal a trend reversal. What is being signaled is a change in trend. The breaking of a major up trend line might signal the beginning of a sideways price pattern, which later would be identified as either the reversal or consolidation type. Sometimes the breaking of the major trend line coincides with the completion of the price pattern. The larger the pattern, the greater the potential. When we use the term larger, we are referring to the height and the width of the price pattern. The height measures the volatility of the pattern. The width is the amount of time required to build and complete the pattern. The greater the size of the pattern, that is, the wider the price swings within the pattern, the volatility, and the longer it takes to build, the more important the pattern becomes and the greater the potential for the ensuing price move. Virtually all of the measuring techniques in these two chapters are based on the height of the pattern. This is the method applied primarily to bar charts, which use a vertical measuring criteria. The practice of measuring the horizontal width of a price pattern usually is reserved for point and figure charting. That method of charting uses a device known as the count, which assumes a close relationship between the width of a top or bottom and the subsequent price target. Differences between tops and bottoms Topping patterns are usually shorter in duration and are more volatile than bottoms. Price swings within the tops are wider and more violent. Tops usually take less time to form. Bottoms usually have smaller price ranges, but take longer to build. For this reason, it is usually easier and less costly to identify and trade bottoms than to catch market tops. One consoling factor, which makes the more treacherous topping patterns worthwhile, is that prices tend to decline faster than they go up. Therefore, the trader can usually make more money a lot faster by catching the short side of a bear market than by trading the long side of a bull market. Everything in life is a trade-off between reward and risk. The greater risks are compensated for by greater rewards and vice versa. Topping patterns are harder to catch, but are worth the effort. Volume is more important on the upside. Volume should generally increase in the direction of the market trend and is an important confirming factor in the completion of all price patterns. The completion of each pattern should be accompanied by a noticeable increase in volume. However, in the early stages of a trend reversal, volume is not as important at market tops. Markets have a way of falling of their own weight once a bear move gets underway. Tartists like to see an increase in trading activity as prices drop, but it is not critical. At bottoms, however, the volume pickup is absolutely essential. If the volume pattern does not show a significant increase during the upside price breakout, the entire price pattern should be questioned. We will be taking a more in-depth look at volume in chapter 7. The Head and Shoulders Reversal Pattern Let's take a close look now at what is probably the best known and most reliable of all major reversal patterns. The Head and Shoulders Reversal. We'll spend more time on this pattern because it is important, and also to explain all the nuances involved. Most of the other reversal patterns are just variations of the head and shoulders and will not require as extensive a treatment. This major reversal pattern, like all of the others, is just a further refinement of the concepts of trend covered in chapter 4. Picture a situation in a major uptrend, where a series of ascending peaks and troughs gradually begin to lose momentum. The uptrend then levels off for a while. During this time, the forces of supply and demand are in relative balance. Once this distribution phase has been completed, support levels along the bottom of the horizontal trading range are broken. And a new downtrend has been established. That new downtrend now has descending peaks and troughs. Let's see how this scenario would look on a Head and Shoulders top, see figures 5.1A and B. At point A, the uptrend is proceeding as expected with no signs of a top. Volume expands on the price move into new highs, which is normal. The corrective dip to point B is on lighter volume, which is also to be expected. At point C, however, the alert chartists might notice that the volume on the upside breakout through point A is a bit lighter than on the previous rally. This change is not in itself of major importance, but a little yellow caution light goes on in the back of the analyst's head. Prices then begin to decline to point D, and something even more disturbing happens. The decline carries below the top of the previous peak at point A. Remember that, in an uptrend, a penetrated peak should function as support on subsequent corrections. The decline well under point A, almost to the previous reaction low at point B, is another warning that something may be going wrong with the uptrend. The market rallies again to point E, this time on even lighter volume, and isn't able to reach the top of the previous peak at point C. That last rally at point E will often retrace one-half to two-thirds of the decline from point C to D. To continue an uptrend, each high point must exceed the high point of the rally preceding it. The failure of the rally at point E to reach the previous peak at point C fulfills half of the requirement for a new downtrend, namely, descending peaks. By this time, the major uptrend line, Line 1, has already been broken, usually at point D, constituting another danger signal. But, despite all of these warnings, all that we know at this point is that the trend has shifted from up to sideways. This might be sufficient cause to liquidate long positions, but not necessarily enough to justify new short sales. The breaking of the neckline completes the pattern. By this time, a flatter trend line can be drawn under the last two reaction lows, points B and D, which is called a neckline, C line 2. This line generally has a slight upward slope at tops, although it's sometimes horizontal, and, less often, tilts downward. The deciding factor in the resolution of the head and shoulders top is a decisive closing violation of that neckline. The market has now violated the trend line along the bottom of points B and D, has broken under support at point D, and has completed the requirement for a new downtrend, descending peaks and troughs. The new downtrend is now identified by the declining highs and lows at points C, D, E, and F. Volume should increase on the breaking of the neckline. A sharp increase in downside volume, however, is not critically important in the initial stages of a market top. The return move. Usually a return move develops, which is a bounce back to the bottom of the neckline or to the previous reaction low at point D, C, point G, both of which have now become overhead resistance. A return move does not always occur, or is sometimes only a very minor bounce. Volume may help determine the size of the bounce. If the initial breaking of the neckline is on very heavy trading, the odds for a return move are diminished, because the increased activity reflects greater downside pressure. Lighter volume on the initial break of the neckline increases the likelihood of a return move. That bounce, however, should be on light volume, and the subsequent resumption of the new downtrend should be accompanied by noticeably heavier trading activity. Summary Summary Let's review the basic ingredients for a head and shoulders top. 1. A prior uptrend 2. A left shoulder on heavier volume, point A, followed by a corrective dip to point B. 3. A rally into new highs, but on lighter volume, point C. 4. A decline that moves below the previous peak, at A, and approaches the previous reaction low, point D. 5. A third rally, point E, on noticeably light volume that fails to reach the top of the head, at point C. 6. A close below the neckline. 7. A return move, back to the neckline, point G, followed by new lows. What has become evident is three well-defined peaks. The middle peak, the head, is slightly higher than either of the two shoulders, points A and E. The pattern, however, is not complete until the neckline is decisively broken on a closing basis. Here again, the 1-3% penetration criterion, or some variation thereof, or the requirement of two successive closes below the neckline, the two-day rule, can be used for added confirmation. Until that downside violation takes place, however, there is always the possibility that the pattern is not really a head and shoulders top, and that the uptrend may resume at some point. The importance of volume. The accompanying volume pattern plays an important role in the development of the head and shoulders top, as it does in all price patterns. As a general rule, the second peak, the head, should take place on lighter volume than the left shoulder. This is not a requirement, but a strong tendency, and an early warning of diminishing buying pressure. The most important volume signal takes place during the third peak, the right shoulder. Volume should be noticeably lighter than on the previous two peaks. Volume should then expand on the breaking of the neckline, decline during the return move, and then expand again once the return move is over. As mentioned earlier, volume is less critical during the completion of market tops. But, at some point, volume should begin to increase if the new downtrend is to be continued. Volume plays a much more decisive role at market bottoms, a subject to be discussed shortly. Before doing so, however, let's discuss the measuring implications of the head and shoulders pattern. Finding a price objective The method of arriving at a price objective is based on the height of the pattern. Take the vertical distance from the head, point C, to the neckline. Then, project that distance from the point where the neckline is broken. Assume, for example, that the top of the head is at 100, and the neckline is at 80. The vertical distance, therefore, would be the difference, which is 20. That 20 points would be measured downward from the level at which the neckline is broken. If the neckline in figure 5.1a is at 82 when broken, a downside objective would be projected to the 62 level. 82 minus 20 equals 62. Another technique that accomplishes about the same task, but is a bit easier, is to simply measure the length of the first wave of the decline, points C to D, and then double it. In either case, the greater the height or volatility of the pattern, the greater the objective. Chapter 4 stated that the measurement taken from a trendline penetration was similar to that used in the head and shoulders pattern. You should be able to see that now. Prices travel roughly the same distance below the broken neckline as they do above it. We see throughout our entire study of price patterns that most price targets on bar charts are based on the height or volatility of the various patterns. The theme of measuring the height of the pattern and then projecting that distance from a breakout point will be constantly repeated. It's important to remember that the objective arrived at is only a minimum target. Prices will often move well beyond the objective. Having a minimum target to work with, however, is very helpful in determining beforehand whether there is enough potential in a market move to warrant taking a position. If the market exceeds the price objective, that's just icing on the cake. The maximum objective is the size of the prior move. If the previous bull market went from 30 to 100, then the maximum downside objective from a topping pattern would be a complete retracement of the entire UP move all the way down to 30. Reversal patterns can only be expected to reverse or retrace what has gone before them. Adjusting price objectives. A number of other factors should be considered while trying to arrive at a price objective. The measuring techniques from price patterns, such as the one just mentioned for the head and shoulders top, are only the first step. There are other technical factors to take into consideration. For example, where are the prominent support levels left by the reaction lows during the previous bull move? Bear markets often pause at these levels. What about percentage retracements? The maximum objective would be a 100% retracement of the previous bull market. But where are the 50% and 66% retracement levels? Those levels often provide significant support under the market. What about any prominent gaps underneath? Now, they often function as support areas. Are there any long-term trend lines visible below the market? The technician must consider other technical data in trying to pinpoint price targets taken from price patterns. If a downside price measurement, for example, projects a target to 30 and there is a prominent support level at 32, then the chartist would be wise to adjust the downside measurement to 32 instead of 30. As a general rule, when a slight discrepancy exists between a projected price target and a clear-cut support or resistance level, it's usually safe to adjust the price target to that support or resistance level. It is often necessary to adjust the measured targets from price patterns to take into account additional technical information. The analyst has many different tools at his or her disposal. The most skillful technical analysts are those who learn to blend all of those tools together properly. The inverse head and shoulders. The head and shoulders bottom, or the inverse head and shoulders as it is sometimes called, is pretty much a mirror image of the topping pattern. As figure 5.2a shows, there are three distinct bottoms with the head, middle trough, a bit lower than either of the two shoulders. A decisive close through the neckline is also necessary to complete the pattern, and the measuring technique is the same. One slight difference at the bottom is the greater tendency for the return move back to the neckline to occur after the bullish breakout. See figure 5.2b. The most important difference between the top and bottom patterns is the volume sequence. Volume plays a much more critical role in the identification and completion of a head and shoulders bottom. This point is generally true of all bottom patterns. It was stated earlier that markets have a tendency to fall of their own weight. At bottoms, however, markets require a significant increase in buying pressure, reflected in greater volume, to launch a new bull market. A more technical way of looking at this difference is that a market can fall just from inertia. Lack of demand or buying interest on the part of traders is often enough to push a market lower, but a market does not go up on inertia. Prices only rise when demand exceeds supply, and buyers are more aggressive than sellers. The volume pattern at the bottom is very similar to that at the top for the first half of the pattern. That is, the volume at the head is a bit lighter than that at the left shoulder. The rally from the head, however, should begin to show not only an increase in trading activity, but the level of volume often exceeds that registered on the rally from the left shoulder. The dip to the right shoulder should be on very light volume. The critical point occurs at the rally through the neckline. The signal must be accompanied by a sharp burst of trading volume if the breakout is for real. This point is where the bottom differs the most from the top. At the bottom, heavy volume is an absolutely essential ingredient in the completion of the basing pattern. The return move is more common at bottoms than at tops and should occur on light volume. Following that, the new uptrend should resume on heavier volume. The measuring technique is the same as at the top. The slope of the neckline. The neckline at the top usually slopes slightly upward. Sometimes, however, it is horizontal. In either case, it doesn't make too much of a difference. Once in a while, however, a top neckline slopes downward. This slope is a sign of market weakness and is usually accompanied by a weak right shoulder. However, this is a mixed blessing. The analyst waiting for the breaking of the neckline to initiate a short position has to wait a bit longer because the signal from the down-sloping neckline occurs much later and only after much of the move has already taken place. For basing patterns, most necklines have a slight downward tilt. A rising neckline is a sign of greater market strength but with the same drawback of giving a later signal. Complex head and shoulders patterns. A variation of the head and shoulders pattern sometimes occurs, which is called the complex head and shoulders pattern. These are patterns where two heads may appear or a double left and right shoulder. These patterns are not that common but have the same forecasting implications. A helpful hint in this regard is the strong tendency towards symmetry in the head and shoulders pattern. This means that a single left shoulder usually indicates a single right shoulder. A double left shoulder increases the odds of a double right shoulder. Tactics. Market tactics play an important role in all trading. Not all technical traders like to wait for the breaking of the neckline before initiating a new position. As figure 5.3 shows, more aggressive traders, believing that they have correctly identified a head and shoulders bottom, will begin to probe the long side during the formation of the right shoulder. Or they will buy the first technical signal that the decline into the right shoulder has ended. Some will measure the distance of the rally from the bottom of the head. From points C to D, and then buy a 50% or 66% retracement of that rally. Still others would draw a tight down trend line along the decline from points D to E, and buy the first upside break of that trend line. Because these patterns are reasonably symmetrical, some will buy into the right shoulder as it approaches the same level as the bottom of the left shoulder. A lot of anticipatory buying takes place during the formation of the right shoulder. If the initial long probe proves to be profitable, additional positions can be added on the actual penetration of the neckline or on the return move back to the neckline after the breakout. The failed head and shoulders pattern. Once prices have moved through the neckline and completed a head and shoulders pattern, prices should not recross the neckline again. At a top, once the neckline has been broken on the downside, any decisive close back above the neckline is a serious warning that the initial breakdown was probably a bad signal and creates what is often called, for obvious reasons, a failed head and shoulders. This type of pattern starts out looking like a classic head and shoulders reversal, but at some point in its development, either prior to the breaking of the neckline or just after it, prices resume their original trend. There are two important lessons here. The first is that none of these chart patterns are infallible. They work most of the time, but not always. A second lesson is that technical traders must always be on the alert for chart signs that their analysis is incorrect. One of the keys to survival in the financial markets is to keep trading losses small and to exit a losing trade as quickly as possible. One of the greatest advantages of chart analysis is its ability to quickly alert the trader to the fact that he or she is on the wrong side of the market. The ability and willingness to quickly recognize trading errors and to take defensive action immediately are qualities not to be taken lightly in the financial markets. The head and shoulders as a consolidation pattern. Before moving on to the next price pattern, there's one final point to be made on the head and shoulders. We started this discussion by listing it as the best known and most reliable of the major reversal patterns. You should be warned, however, that this formation can, on occasion, act as a consolidation rather than a reversal pattern. When this does happen, it's the exception rather than the rule. We'll talk more about this in Chapter 6: Continuation Patterns Triple Tops and Bottoms Most of the points covered in the treatment of the head and shoulders pattern are also applicable to other types of reversal patterns. See figures 5.4a to C. The triple top or bottom, which is much rarer in occurrence, is just a slight variation of that pattern than routes. The main difference is that the three peaks or troughs in the triple top or bottom are at about the same level. See figure 5.4a. Chartists often disagree as to whether a reversal pattern is a head and shoulders or a triple top. The argument is academic because both patterns imply the exact same thing. The volume tends to decline with each successive peak at the top and should increase at the breakdown point. The triple top is not complete until support levels along both of the intervening lows have been broken. Conversely, prices must close through the two intervening peaks at the bottom to complete a triple bottom. As an alternate strategy, the breaking of the nearest peak or trough can also be used as a reversal signal. Heavy upside volume on the completion of the bottom is also essential. The measuring implication is also similar to the head and shoulders and is based on the height of the pattern. Prices will usually move a minimum distance from the breakout point at least equal to the height of the pattern. Once the breakout occurs, a return move to the breakout point is not unusual. Because the triple top or bottom represents only a minor variation of the head and shoulders pattern, we won't say much more about it here. Double tops and bottoms. A much more common reversal pattern is the double top or bottom. Next to the head and shoulders, it is the most frequently seen and the most easily recognized. See figures 5.5 A to E. Figures 5.5 A and 5.5 B show both the top and bottom variety. For obvious reasons, the top is often referred to as an M and the bottom as a W. The general characteristics of a double top are similar to that of the head and shoulders and triple top, except that only two peaks appear instead of three. The volume pattern is similar, as is the measuring rule. In an uptrend, as shown in figure 5.5 A, the market sets a new high at point A, usually on increased volume, and then declines to point B on declining volume. So far, everything is proceeding as expected in a normal uptrend. The next rally to point C, however, is unable to penetrate the previous peak at A on a closing basis and begins to fall back again. A potential double top has been set up. I use the word potential because, as is the case with all reversal patterns, the reversal is not complete until the previous support point at B is violated on a closing basis. Until that happens, prices could be in just a sideways consolidation phase, preparing for a resumption of the original uptrend. The ideal top has two prominent peaks at about the same price level. Volume tends to be heavier during the first peak and lighter on the second. A decisive close under the middle trough at point B on heavier volume completes the pattern and signals a reversal of trend to the downside. A return move to the breakout point is not unusual prior to resumption of the downtrend. Measuring technique for the double top The measuring technique for the double top is the height of the pattern projected from the breakdown point, the point where the middle trough at point B is broken. As an alternative, measure the height of the first down leg, points A to B, and project that length downward from the middle trough at point B. Measurements at the bottom are the same, but in the other direction. Variations from the ideal pattern As in most other areas of market analysis, real-life examples are usually some variation of the ideal. For one thing, sometimes the two peaks are not at exactly the same price level. On occasion, the second peak will not quite reach the level of the first peak, which is not too problematical. What does cause some problems is when the second peak actually exceeds the first peak by a slight margin. What at first may appear to be a valid upside breakout and resumption of the uptrend may turn out to be part of the topping process. To help resolve this dilemma, some of the filtering criteria already mentioned may come in handy. Filters Most chartists require a close beyond a previous resistance peak instead of just an intraday penetration. Second, a price filter of some type might be used. One such example is a percentage penetration criterion, such as 1% or 3%. Third, the two-day penetration rule could be used as an example of a time filter. In other words, prices would have to close beyond the top of the first peak for two consecutive days to signal a valid penetration. Another time filter could be a Friday close beyond the previous peak. The volume on the upside breakout might also provide a clue to its reliability. These filters are certainly not infallible, but do serve to reduce the number of false signals, or whipsaws, that often occur. Sometimes these filters are helpful, and sometimes they're not. The analyst must face the realization that he or she is dealing with percentages and probabilities, and that there will be times when bad signals occur. That's simply a fact of trading life. It's not that unusual for the final leg or wave of a bull market to set a new high before reversing direction. In such a case, the final upside breakout would become a bull trap. See figures 5.6 A and B. We'll show you some indicators later on that may help you spot these false breakouts. The term "double top" greatly overused. The terms "double top" and "bottom" are greatly overused in the financial markets. The most potential "double tops" or "bottoms" wind up being something else. The reason for this is that prices have a strong tendency to back off from a previous peak or bounce off a previous low. These price changes are a natural reaction and do not in themselves constitute a reversal pattern. Remember that, at a top, prices must actually violate the previous reaction low before the double top exists. Notice in figure 5.7 A that the price at point C backs off from the previous peak at point A. This is perfectly normal action in an uptrend. Many traders, however, will immediately label this pattern as a "double top" as soon as prices fail to clear the first peak on the first attempt. Figure 5.7 B shows the same situation in a downtrend. It is very difficult for the chartist to determine whether the pullback from the previous peak or the bounce from the previous low is just a temporary setback in the existing trend or the start of a double top or bottom reversal pattern. Because the technical odds usually favor continuation of the present trend, it is usually wise to await completion of the pattern before taking action. Time between peaks or troughs is important. Finally, the size of the pattern is always important. The longer the time period between the two peaks and the greater the height of the pattern, the greater the potential impending reversal. This is true of all chart patterns. In general, most valid double tops or bottoms should have at least a month between the two peaks or troughs. Some will even be two or three months apart. On longer range monthly and weekly charts, these patterns can span several years. Most of the examples used in this discussion have described market tops. The reader should be aware by now that bottoming patterns are mirror images of tops, except for some of the general differences already touched upon at the beginning of the chapter. Saucers and Spikes Although not seen as frequently, reversal patterns sometimes take the shape of saucers or rounding bottoms. A saucer bottom shows a very slow and very gradual turn from down to sideways to up. It is difficult to tell exactly when the saucer has been completed or to measure how far prices will travel in the opposite direction. Saucer bottoms are usually spotted on weekly or monthly charts that span several years. The longer they last, the more significant they become. See figure 5.8. Spikes are the hardest market turns to deal with. Because the spike, or V pattern, happens very quickly, with little or no transition period. They usually take place in a market that has gotten so overextended in one direction that a sudden piece of adverse news causes the market to reverse direction very abruptly. A daily or weekly reversal on very heavy volume is sometimes the only warning they give us. That being the case, there's not much more we can say about them, except that we hope you don't run into too many of them. Some technical indicators we discuss in later chapters will help you determine when markets have gotten dangerously overextended. See figure 5.9. Conclusion We've discussed the five most commonly used major reversal patterns: the head and shoulders, double and triple tops and bottoms, the saucer, and the V, or spike. Of those, the most common are the head and shoulders, and double tops and bottoms. These patterns usually signal important trend reversals in progress and are classified as major reversal patterns. There is another class of patterns, however, which are shorter term in nature and usually suggest trend consolidations rather than reversals. They are aptly called continuation patterns. Let's look at this other type of pattern in chapter 6. End of chapter 5. Chapter 6. Continuation Patterns Introduction The chart patterns covered in this chapter are called continuation patterns. These patterns usually indicate that the sideways price action on the chart is nothing more than a pause in the prevailing trend, and that the next move will be in the same direction as the trend that preceded the formation. This distinguishes this group of patterns from those in the previous chapter, usually indicate that a major trend reversal is in progress. Another difference between reversal and continuation patterns is their time duration. Reversal patterns usually take much longer to build and represent major trend changes. Continuation patterns, on the other hand, are usually shorter term in duration and are more accurately classified as near term or intermediate patterns. Notice the constant use of the term "usually". The treatment of all chart patterns deals of necessity with general tendencies as opposed to rigid rules. There are always exceptions. Even the grouping of price patterns into different categories sometimes becomes tenuous. Triangles are usually continuation patterns, but sometimes act as reversal patterns. Although triangles are usually considered intermediate patterns, they may occasionally appear on long-term charts and take on major trend significance. A variation of the triangle, the inverted variety, usually signals a major market top. Even the head and shoulders pattern, the best known of the major reversal patterns, will on occasion be seen as a consolidation pattern. Even with allowances for a certain amount of ambiguity and the occasional exception, chart patterns do generally fall into the above two categories and, if properly interpreted, can help the chartist determine what the market will probably do most of the time. Triangles. Let's begin our treatment of continuation patterns with the triangle. There are three types of triangles: symmetrical, ascending, and descending. Some chartists include a fourth type of triangle, known as an expanding triangle, or broadening formation. This is treated as a separate pattern later. Each type of triangle has a slightly different shape and has different forecasting implications. Figures 6.1a-C show examples of what each triangle looks like. The symmetrical triangle, see figure 6.1a, shows two converging trendlines: the upper line descending and the lower line ascending. The vertical line at the left, measuring the height of the pattern, is called the base. The point of intersection at the right, where the two lines meet, is called the apex. For obvious reasons, the symmetrical triangle is also called a coil. The ascending triangle has a rising lower line with a flat or horizontal upper line, see figure 6.1b. The descending triangle, figure 6.1c, by contrast, has the upper line declining with a flat or horizontal bottom line. Let's see how each one is interpreted. The symmetrical triangle. The symmetrical triangle, or the coil, is usually a continuation pattern. It represents a pause in the existing trend, after which the original trend is resumed. In the example in figure 6.1a, the prior trend was up, so that the percentages favor resolution of the triangular consolidation on the upside. If the trend had been down, then the symmetrical triangle would have bearish implications. The minimum requirement for a triangle is four reversal points. Remember that it always takes two points to draw a trend line. Therefore, in order to draw two converging trend lines, each line must be touched at least twice. In figure 6.1a, the triangle actually begins at point 1, which is where the consolidation in the uptrend begins. Prices pull back to point 2, and then rally to point 3. Point 3, however, is lower than point 1. The upper trend line can only be drawn once prices have declined from point 3. Notice that point 4 is higher than point 2. Only when prices have rallied from point 4 can the lower upslanting line be drawn. It is at this point that the analyst begins to suspect that he or she is dealing with the symmetrical triangle. Now, there are four reversal points, 1, 2, 3, and 4, and two converging trend lines. While the minimum requirement is four reversal points, many triangles have six reversal points, as shown in figure 6.1a. This means that there are actually three peaks and three troughs that combine to form five waves within the triangle before the uptrend resumes. When we get to the Elliott Wave Theory, we'll have more to say about the five-wave tendency within triangles. Time Limit for Triangle Resolution There is a time limit for the resolution of the pattern, and that is the point where the two lines meet at the apex. As a general rule, prices should break out in the direction of the prior trend, somewhere between two-thirds to three-quarters of the horizontal width of the triangle. That is, the distance from the vertical base on the left of the pattern to the apex at the far right. Because the two lines must meet at some point, that time distance can be measured once the two converging lines are drawn. An upside breakout is signaled by a penetration of the upper trend line. If prices remain within the triangle beyond the three-quarters point, the triangle begins to lose its potency, and usually means that prices will continue to drift out to the apex and beyond. The triangle, therefore, provides an interesting combination of price and time. The converging trend lines give the price boundaries of the pattern, and indicate at what point the pattern has been completed, and the trend resumed by the penetration of the upper trend line, in the case of an uptrend. But these trend lines also provide a time target by measuring the width of the pattern. If the width, for example, were 20 weeks long, then the breakout should take place sometime between the 13th and the 15th week. See figure 6.1D. The actual trend signal is given by a closing penetration of one of the trend lines. Sometimes a return move will occur back to the penetrated trend line after the breakout. In an uptrend, that line has become a support line. In a downtrend, the lower line becomes a resistance line once it's broken. The apex also acts as an important support or resistance level after the breakout occurs. Various penetration criteria can be applied to the breakout, similar to those covered in the previous two chapters. A minimum penetration criterion would be a closing price outside the trend line, and not just an intraday penetration. Importance of volume: Volume should diminish as the price swings narrow within the triangle. This tendency for volume to contract is true of all consolidation patterns. But the volume should pick up noticeably at the penetration of the trend line that completes the pattern. The return move should be on light volume with heavier activity again as the trend resumes. Two other points should be mentioned about volumes. As is the case with reversal patterns, volume is more important on the upside than on the downside. An increase in volume is essential to the resumption of an uptrend in all consolidation patterns. The second point about volume is that even though trading activity diminishes during formation of the pattern, a close inspection of the volume usually gives a clue as to whether the heavier volume is occurring during the up moves or down moves. In an uptrend, for example, there should be a slight tendency for volume to be heavier during the bounces and lighter on the price dips. Measuring Technique: Triangles have measuring techniques. In the case of the symmetrical triangle, there are a couple of techniques generally used. The simplest technique is to measure the height of the vertical line at the widest part of the triangle, the base, and measure that distance from the breakout point. Figure 6.2 shows the distance projected from the breakout point, which is the technique I prefer. The second method is to draw a trend line from the top of the base at point A parallel to the lower trend line. This upper channel line then becomes the upside target in an uptrend. It is possible to arrive at a rough time target for prices to meet the upper channel line. Prices will sometimes hit the channel line at the same time the two converging lines meet at the apex. The Ascending Triangle: The ascending and descending triangles are variations of the symmetricals but have different forecasting implications. Figures 6.3 A and B show examples of an ascending triangle. Notice that the upper trend line is flat while the lower line is rising. This pattern indicates that buyers are more aggressive than sellers. It is considered a bullish pattern and is usually resolved with a breakout to the upside. Both the ascending and descending triangles differ from the symmetrical in a very important sense. No matter where in the trend structure the ascending or descending triangles appear, they have very definite forecasting implications. The ascending triangle is bullish and the descending triangle is bearish. The symmetrical triangle, by contrast, is inherently a neutral pattern. This does not mean, however, that the symmetrical triangle does not have forecasting value. On the contrary, because the symmetrical triangle is a continuation pattern, the analyst must simply look to see the direction of the previous trend and then make the assumption that the previous trend will continue. Let's get back to the ascending triangle. As already stated, more often than not, the ascending triangle is bullish. The bullish breakout is signaled by a decisive closing above the flat upper trend line. As in the case of all valid upside breakouts, volume should see a noticeable increase on the breakout. A return move back to the support line, the flat upper line, is not unusual and should take place on light volume. Measuring technique. The measuring technique for the ascending triangle is relatively simple. Simply measure the height of the pattern at its widest point and project that vertical distance from the breakout point. This is just another example of using the volatility of a price pattern to determine a minimum price objective. The ascending triangle as a bottom. While the ascending triangle most often appears in an uptrend and is considered a continuation pattern, it sometimes appears as a bottoming pattern. It is not unusual toward the end of a downtrend to see an ascending triangle develop. However, even in this situation, the interpretation of the pattern is bullish. The breaking of the upper line signals completion of the base and is considered a bullish signal. Both the ascending and descending triangles are sometimes also referred to as right angle triangles. The descending triangle. The descending triangle is just a mirror image of the ascending and is generally considered a bearish pattern. Notice in figures 6.4 A and B, the descending upper line and the flat lower line. This pattern indicates that sellers are more aggressive than buyers and is usually resolved on the downside. The downside signal is registered by a decisive close under the lower trend line, usually on increased volume. A return move sometimes occurs, which should encounter resistance at the lower trend line. The measuring technique is exactly the same as the ascending triangle. In the sense that the analyst must measure the height of the pattern at the base to the left and then project that distance down from the breakdown point. The descending triangle as a top. While the descending triangle is a continuation pattern and usually is found within downtrends, it is not unusual on occasion for the descending triangle to be found at market tops. This type of pattern is not that difficult to recognize when it does appear in the top setting. In that case, a close below the flat lower line would signal a major trend reversal to the downside. The volume pattern. The volume pattern in both the ascending and descending triangles is very similar in that the volume diminishes as the pattern works itself out and then increases on the breakout. As in the case of the symmetrical triangle, during the formation the chartist can detect subtle shifts in the volume pattern coinciding with the swings in the price action. This means that in the ascending pattern, the volume tends to be slightly heavier on bounces and lighter on dips. In the descending formation, volume should be heavier on the downside and lighter during the bounces. The time factor in triangles. One final factor to be considered on the subject of triangles is that of the time dimension. The triangle is considered an intermediate pattern, meaning that it usually takes longer than a month to form, but generally less than three months. A triangle that lasts less than a month is probably a different pattern, such as a pennant, which will be covered shortly. As mentioned earlier, triangles sometimes appear on long-term price charts, but their basic meaning is always the same. The broadening formation. This next price pattern is an unusual variation of the triangle and is relatively rare. It is actually an inverted triangle or a triangle turned backwards. All of the triangular patterns examined so far show converging trend lines. The broadening formation, as the name implies, is just the opposite. As the pattern in figure 6.5 shows, the trend lines actually diverge in the broadening formation, creating a picture that looks like an expanding triangle. It is also called a megaphone top. The volume pattern also differs in this formation. In the other triangular patterns, volume tends to diminish as the price swings grow narrower. Just the opposite happens in the broadening formation. The volume tends to expand along with the wider price swings. This situation represents a market that is out of control and unusually emotional. Because this pattern also represents an unusual amount of public participation, it most often occurs at major market tops. The expanding pattern, therefore, is usually a bearish formation. It generally appears near the end of a major bull market. Flags and pennants. The flag and pennant formations are quite common. They are usually treated together because they are very similar in appearance. They tend to show up at about the same place in an existing trend and have the same volume and measuring criteria. The flag and pennant represent brief pauses in a dynamic market move. In fact, one of the requirements for both the flag and the pennant is that they be preceded by a sharp and almost straight-line move. They represent situations where a steep advance or decline has gotten ahead of itself and where the market pauses briefly to "catch its breath" before running off again in the same direction. Flags and pennants are among the most reliable of continuation patterns and only rarely produce a trend reversal. Figures 6.6 A to B show what these two patterns look like. To begin with, notice the steep price advance preceding the formations on heavy volume. Notice also the dramatic drop-off in activity as the consolidation patterns form and then the sudden burst of activity on the upside breakout. Construction of flags and pennants. The construction of the two patterns differs slightly. The flag resembles a parallelogram or rectangle marked by two parallel trend lines that tend to slope against the prevailing trend. In a downtrend, the flag would have a slight upward slope. The pennant is identified by two converging trend lines and is more horizontal. It very closely resembles a small symmetrical triangle. An important requirement is that volume should dry up noticeably while each of the patterns is forming. Both patterns are relatively short-term and should be completed within one to three weeks. Pennants and flags and downtrends tend to take even less time to develop and often last no longer than one or two weeks. Both patterns are completed on the penetration of the upper trend line. In an uptrend, the breaking of the lower trend line would signal resumption of downtrends. The breaking of those trend lines should take place on heavier volume. As usual, upside volume is more critically important than downside volume. C. See figure 6.7 A to B. Measuring Implications. The measuring implications are similar for both patterns. Flags and pennants are said to fly at half-mast from a flagpole. Flagpole is the prior sharp advance or decline. The term "half-mast" suggests that these minor continuation patterns tend to appear at about the halfway point of the move. And, in general, the move after the trend has resumed will duplicate the flagpole or the move just prior to the formation of the pattern. To be more precise, measure the distance of the preceding move from the original breakout point. That is to say, the point at which the original trend signal was given, either by the penetration of a support or resistance level or an important trend line. That vertical distance of the preceding move is then measured from the breakout point of the flag or pennant. That is, the point at which the upper line is broken in an uptrend or the lower line in a downtrend. Summary Let's summarize the more important points of both patterns. 1. They are both preceded by an almost straight-line move, called the flagpole, on heavy volume. 2. Prices then pause for about one to three weeks on very light volume. 3. The trend resumes on a burst of trading activity. 4. Both patterns occur at about the midpoint of the market move. 5. The pennant resembles a small horizontal symmetrical triangle. 6. The flag resembles a small parallelogram that slopes against the prevailing trend. 7. Both patterns take less time to develop in downtrends. 8. Both patterns are very common in the financial markets. The wedge formation. The wedge formation is similar to a symmetrical triangle both in terms of its shape and the amount of time it takes to form. Like the symmetrical triangle, it is identified by two converging trend lines that come together at an apex. In terms of the amount of time it takes to form, the wedge usually lasts more than one month, but not more than three months, putting it into the intermediate category. What distinguishes the wedge is its noticeable slant. The wedge pattern has a noticeable slant either to the upside or the downside. As a rule, like the flag pattern, the wedge slants against the prevailing trend. Therefore, a falling wedge is considered bullish and a rising wedge is bearish. Notice in figure 6.8a that the bullish wedge slants downward between two converging trend lines. In the downtrend in figure 6.8b, the converging trend lines have an unmistakable upward slant. Wedges as tops and bottom reversal patterns. Wedges show up most often within the existing trend and usually constitute continuation patterns. The wedge can appear at tops or bottoms and signal a trend reversal, but that type of situation is much less common. Near the end of an uptrend, the chartist may observe a clear-cut rising wedge. Because a continuation wedge in an uptrend should slope downward against the prevailing trend, the rising wedge is a clue to the chartist that this is a bearish and not a bullish pattern. At bottoms, a falling wedge would be a tip-off of a possible end of a bear trend. Whether the wedge appears in the middle or the end of a market move, the market analyst should always be guided by the general maxim that a rising wedge is bearish and a falling wedge is bullish. See figure 6.8c. The rectangle formation. The rectangle formation often goes by other names, but is usually easy to spot on a price chart. It represents a pause in the trend during which prices move sideways between two parallel horizontal lines. See figure 6.9a to seats. The rectangle is sometimes referred to as a trading range or a congestion area. In Dow theory parlance, it is referred to as a line. Whatever it is called, it usually represents just a consolidation period in the existing trend, and is usually resolved in the direction of the market trend that preceded its occurrence. In terms of forecasting value, it can be viewed as being similar to the symmetrical triangle but with flat instead of converging trend lines. A decisive close outside either the upper or lower boundary signals completion of the rectangle and points the direction of the trend. The market analyst must always be on the alert, however, that the rectangular consolidation does not turn into a reversal pattern. In the uptrend shown in figure 6.9a, for example, notice that the three peaks might initially be viewed as a possible triple top reversal pattern. The importance of the volume pattern. One important clue to watch for is the volume pattern. Because the price swings in both directions are fairly broad, the analyst should keep a close eye on which moves have the heavier volume. If the rallies are on heavier and the setbacks on lighter volume, then the formation is probably a continuation in the uptrend. If the heavier volume is on the downside, then it can be considered a warning of a possible trend reversal in the works. Swings within the range can be traded. Some chartists trade the swings within such a pattern by buying dips near the bottom and selling rallies near the top of the range. This technique enables the short-term trader to take advantage of the well-defined price boundaries and profit from an otherwise trendless market. Because the positions are being taken at the extremes of the range, the risks are relatively small and well-defined. If the trading range remains intact, this counter-trend trading approach works quite well. When a breakout does occur, the trader not only exits the last losing trade immediately, but can reverse the previous position by initiating a new trade in the direction of the new trend. Oscillators are especially useful in sideways trading markets, but less useful once the breakout has occurred, for reasons discussed in Chapter 10. Other traders assume the rectangle is a continuation pattern and take long positions near the lower end of the price band in an uptrend, or initiate short positions near the top of the range in downtrends. Others avoid such trendless markets altogether, and await a clear-cut breakout before committing their funds. Most trend-following systems perform very poorly during these periods of sideways and trendless market action. Other Similarities and Differences In terms of duration, the rectangle usually falls into the 1-3 month category, similar to triangles and wedges. The volume pattern differs from other continuation patterns, in the sense that the broad price swings prevent the usual drop-off in activity seen in other such patterns. The most common measuring technique applied to the rectangle is based on the height of the price range. Measure the height of the trading range, from top to bottom, and then project that vertical distance from the breakout point. This method is similar to the other vertical measuring techniques already mentioned, and is based on the volatility of the market. When we cover the count and point-and-figure charting, we'll say more on the question of horizontal price measurements. Everything mentioned so far concerning volume on breakouts and the probability of return moves applies here as well. Because the upper and lower boundaries are horizontal and so well-defined in the rectangle, support and resistance levels are more clearly evident. This means that, on upside breakouts, the top of the former price band should now provide solid support on any sell-offs. After a downside breakout in downtrends, the bottom of the trading range, the previous support area, should now provide a solid ceiling over the market on any rally attempts. The measured move The measured move, or the swing measurement as it is sometimes called, describes the phenomenon where a major market advance or decline is divided into two equal and parallel moves, as shown in Figure 6.10A. For this approach to work, the market move should be fairly orderly and well-defined. The measured move is really just a variation of some of the techniques we've already touched on. We've seen that some of the consolidation patterns, such as flags and pennants, usually occur at about the halfway point of a market move. We've also mentioned the tendency of markets to retrace about a third to a half of a prior trend before resuming that trend. In the measured move, when the chartist sees a well-defined situation, such as in Figure 6.10A, with a rally from point A to point B, followed by a counter-trend swing from point B to point C, which retraces a third to a half of wave AB, it is assumed that the next leg in the uptrend, CD, will come close to duplicating the first leg, AB. This cap, the height of wave AB, therefore, is simply measured upward from the bottom of the correction at point C. The continuation head and shoulders pattern. In the previous chapter, we treated the head and shoulders pattern at some length and described it as the best-known and most trustworthy of all reversal patterns. The head and shoulders pattern can sometimes appear as a continuation instead of a reversal pattern. In the continuation head and shoulders variety, prices trace out a pattern that looks very similar to a sideways rectangular pattern, except that the middle trough, in an uptrend, see Figure 6.11A, tends to be lower than either of the two shoulders. In a downtrend, see Figure 6.11B, the middle peak in the consolidation exceeds the other two peaks. The result in both cases is a head and shoulders pattern turned upside down. Because it is turned upside down, there is no chance of confusing it with the reversal pattern. Confirmation and Divergence The principle of confirmation is one of the common themes running throughout the entire subject of market analysis, and is used in conjunction with its counterpart, divergence. We'll introduce both concepts here and explain their meaning, but we'll return to them again and again throughout the book, because their impact is so important. We're discussing confirmation here in the context of chart patterns, but it applies to virtually every aspect of technical analysis. Confirmation refers to the comparison of all technical signals and indicators, to ensure that most of those indicators are pointing in the same direction and are confirming one another. Divergence is the opposite of confirmation, and refers to a situation where different technical indicators fail to confirm one another. While it is being used here in a negative sense, divergence is a valuable concept in market analysis, and one of the best early warning signals of impending trend reversals. We'll discuss the principle of divergence at greater length in chapter 10, oscillators and contrary opinion. Conclusion This concludes our treatment of price patterns. We stated earlier that the three pieces of raw data used by the technical analyst were price, volume, and open interest. Most of what we've said so far has focused on price. Let's take a closer look now at volume and open interest, and how they are incorporated into the analytical process. End of chapter six. Chapter seven. Volume and open interest. Introduction Most technicians in the financial markets use a multi-dimensional approach to market analysis by tracking the movement of three sets of figures: price, volume, and open interest. Volume analysis applies to all markets. Open interest applies primarily to futures markets. Chapter three discussed the construction of the daily bar chart, and showed how the three figures were plotted on that type of chart. It was stated then that even though volume and open interest figures are available for each delivery month in futures markets, the total figures are the ones generally used for forecasting purposes. Stock chartists simply plot total volume along with the accompanying price. Most of the discussion of charting theory to this point has concentrated mainly on price action, with some mention of volume. In this chapter, we'll round out the three-dimensional approach by taking a closer look at the role played by volume and open interest in the forecasting process. Volume and open interest as secondary indicators. Let's begin by placing volume and open interest in their proper perspective. Price is by far the most important. Volume and open interest are secondary in importance, and are used primarily as confirming indicators. Of those two, volume is the more important. Volume. Volume is the number of entities traded during the time period under study. Because we'll be dealing primarily with daily bar charts, our main concern is with daily volume. That daily volume is plotted by a vertical bar at the bottom of the chart under the day's price action. See figure 7.1. Volume can be plotted for weekly bar charts as well. In that case, total volume for the week would simply be plotted under the bar representing that week's price action. Volume is usually not used, however, on monthly bar charts. Open interest in futures. The total number of outstanding or unliquidated contracts at the end of the day is open interest. In figure 7.2, open interest is the solid line plotted on the chart under its corresponding price data for the day, but above the volume bars. Remember that official volume and open interest figures are reported a day late in the futures markets, and are, therefore, plotted with a one-day lag. Only estimated volume figures are available for the last trading day. That means that each day the chartist plots the high, low, and closing price bar for the last day of trading, but plots the official volume and open interest figures for the previous day. Open interest represents the total number of outstanding longs or shorts in the market, not the sum of both. Open interest is the number of contracts. A contract must have both a buyer and a seller. Therefore, two market participants, a buyer and a seller, combine to create only one contract. The open interest figure reported each day is followed by either a positive or negative number, showing the increase or decrease in the number of contracts for that day. It is those changes in the open interest levels, either up or down, that give the chartist clues as to the changing character of market participation and give open interest its forecasting value. How changes in open interest occur. In order to grasp the significance of how changes in the open interest numbers are interpreted, the reader must first understand how each trade produces a change in those numbers. Every time a trade is completed on the floor of the exchange, the open interest is affected in one of three ways: it increases, decreases, or stays unchanged. Let's see how those changes occur. In the first case, both the buyer and seller are initiating a new position and a new contract is established. In case two, the buyer is initiating a new long position, but the seller is merely liquidating an old long. One is entering and the other exiting a trade. The result is a standoff and no change takes place in the number of contracts. In case three, the same thing happens except this time it is the seller who is initiating a new short and the buyer who is only covering an old short. Because one of the traders is entering and the other exiting a trade, again, no change is produced. In case four, both traders are liquidating an old position and the open interest decreases accordingly. To sum up, if both participants in a trade are initiating a new position, the open interest will increase. If both are liquidating an old position, the open interest will decline. If, however, one is initiating a new trade while the other is liquidating an old trade, open interest will remain unchanged. By looking at the net change in the total open interest at the end of the day, the chartist is able to determine whether money is flowing into or out of the market. This information enables the analyst to draw some conclusions about the strength or weakness of the current price trend. General Rules for Interpreting Volume and Open Interest The futures technician incorporates volume and open interest information into market analysis. The rules for the interpretation of volume and open interest are generally combined because they are so similar. There are, however, some distinctions between the two that should be addressed. We'll begin here with a statement of the general rules for both. Having done that, we'll then treat each one separately before combining them again at the end. If volume and open interest are both increasing, then the current price trend will probably continue in its present direction, either up or down. If, however, volume and open interest are declining, the action can be viewed as a warning that the current price trend may be nearing an end. Having said that, let's now take a look at volume and open interest separately. See Figure 7.2. Interpretation of Volume for All Markets The level of volume measures the intensity or urgency behind the price move. The heavier volume reflects a higher degree of intensity or pressure. By monitoring the level of volume along with price action, the technician is better able to gauge the buying or selling pressure behind market moves. This information can then be used to confirm price movement or warn that a price move is not to be trusted. See figures 7.3 and 7.4. To state the rule more concisely, volume should increase or expand in the direction of the existing price trend. In an uptrend, volume should be heavier as the price moves higher and should decrease or contract on price dips. As long as this pattern continues, volume is said to be confirming the price trend. The chartist is also watching for signs of divergence. There's that word again. Divergence occurs if the penetration of a previous high by the price trend takes place on declining volume. This action alerts the chartist to diminishing buying pressure. If the volume also shows a tendency to pick up on price dips, the analyst begins to worry that the uptrend is in trouble. Volume as Confirmation in Price Patterns During our treatment of price patterns in Chapters 5 and 6, volume was mentioned several times as an important confirming indicator. One of the first signs of a head and shoulders top occurred when prices moved into new highs during the formation of the head on light volume. With heavier activity on the subsequent decline to the neckline, the double and triple tops saw lighter volume on each successive peak, followed by heavier downside activity. Continuation patterns, like the triangle, should be accompanied by a gradual drop-off in volume. As a rule, the resolution of all price patterns, the breakout point, should be accompanied by heavier trading activity. If the signal given by that breakout is real. See figure 7.5 In a downtrend, the volume should be heavier during down moves and lighter on bounces. As long as that pattern continues, the selling pressure is greater than buying pressure and the downtrend should continue. It's only when that pattern begins to change that the chartist starts looking for signs of a bottom. Volume precedes price. By monitoring the price and volume together, we're actually using two different tools to measure the same thing. Pressure. By the mere fact that prices are trending higher, we can see that there is more buying than selling pressure. It stands to reason, then, that the greater volume should take place in the same direction as the prevailing trend. Technicians believe that volume precedes price, meaning that the loss of upside pressure in an uptrend or downside pressure in a downtrend actually shows up in the volume figures before it is manifested in a reversal of the price trend. On balance volume, technicians have experimented with many volume indicators to help quantify buying or selling pressure. Trying to eyeball the vertical volume bars along the bottom of the chart is not always precise enough to detect significant shifts in the volume flow. The simplest and best known of these volume indicators is on balance volume, or OBV. Developed and popularized by Joseph Granville in his 1963 book, Granville's New Key to Stock Market Profits, OBV, actually produces a curving line on the price chart. This line can be used either to confirm the quality of the current price trend or warn of an impending reversal by diverging from the price action. Figure 7.6 shows the price chart with the OBV line along the bottom of the chart instead of the volume bars. Notice how much easier it is to follow the volume trend with the OBV line. The construction of the OBV line is simplicity itself. The total volume for each day is assigned a plus or minus value, depending on whether prices close higher or lower for that day. A higher close causes the volume for that day to be given a plus value, while a lower close counts for negative volume. A running cumulative total is then maintained by adding or subtracting each day's volume based on the direction of the market close. It is the direction of the OBV line, its trend, that is important, and not the actual numbers themselves. The actual OBV values will differ depending on how far back you are charting. Let the computer handle the calculations. Concentrate on the direction of the OBV line. The on-balance volume line should follow in the same direction as the price trend. If prices show a series of higher peaks and troughs, an uptrend, the OBV line should do the same. If prices are trending lower, so should the OBV lines. It's when the volume line fails to move in the same direction as prices, that a divergence exists, and warns of a possible trend reversal. For alternatives to OBV. The on-balance volume line does its job reasonably well, but it has some shortcomings. For one thing, it assigns an entire day's volume a plus or minus value. Suppose a market closes up on the day by some minimal amount, such as one or two ticks. Is it reasonable to assign all of that day's activity a positive value? Or consider a situation where the market spends most of the day on the upside, but then closes slightly lower. Should all of that day's volume be given a negative value? To resolve these questions, technicians have experimented with many variations of OBV in an attempt to discover the true upside and downside volume. One variation is to give greater weight to those days where the trend is the strongest. On an up day, for example, the volume is multiplied by the amount of the price gain. This technique still assigns positive and negative values, but gives greater weight to those days with greater price movement and reduces the impact of those days where the actual price change is minimal. There are more sophisticated formulas that blend volume and open interest with price action. James Sibbitt's demand index, for example, combines price and volume into a leading market indicator. The Herrick Payoff Index uses open interest to measure money flow. See Appendix A for an explanation of both indicators. It should be noted that volume reporting in the stock market is much more useful than in the futures markets. Stock trading volume is reported immediately, while it is reported a day late for futures. Levels of upside and downside volume are also available for stocks, but not in futures. The availability of volume data for stocks on each price change during the day has facilitated an even more advanced indicator called money flow, developed by Laszlo Berini Jr. This real-time version of OBV tracks the level of volume on each price change in order to determine if money is flowing into or out of a stock. This sophisticated calculation, however, requires a lot of computer power and isn't readily available to most traders. These more sophisticated variations of OBV have basically the same intent to determine whether the heavier volume is taking place on the upside, bullish, or the downside, bearish. Even with its simplicity, the OBV line still does a pretty good job of tracking the volume flow in a market, either in futures or stocks. And OBV is readily available on most charting software. Most charting packages even allow you to plot the OBV line right over the price data for even easier comparisons. See figures 7.7 and 7.8 Other Volume Limitations in Futures We've already mentioned the problem of the one-day lag in reporting futures volume. There is also the relatively awkward practice of using total volume numbers to analyze individual contracts instead of each contract's actual volume. There are good reasons for using total volume, but how does one deal with situations when some contracts close higher and others lower in the same futures market on the same day? Limit days produce other problems. Days when markets are locked limit up usually produce very light volume. This is a sign of strength as the numbers of buyers so overwhelm the sellers that prices reach the maximum trading limit and cease trading. According to the traditional rules of interpretation, light volume on a rally is bearish. The light volume on limit days is a violation of that principle and can distort OBV numbers. Even with these limitations, however, volume analysis can still be used in the futures markets, and the technical trader would be well advised to keep a watchful eye on volume indications. Interpretation of Open Interest in Futures The rules for interpreting open interest changes are similar to those for volume, but require additional explanation. 1. With prices advancing in an uptrend and total open interest increasing, new money is flowing into the market reflecting aggressive new buying and is considered bullish. 2. If, however, prices are rising and open interest declines, the rally is being caused primarily by short covering. Holders of losing short positions being forced to cover those positions. Money is leaving rather than entering the market. This action is considered bearish because the uptrend will probably run out of steam once the necessary short covering has been completed. See figure 7.10. 3. With prices in a downtrend and open interest rising, the technician knows that new money is flowing into the market, reflecting aggressive new short selling. This action increases the odds that the downtrend will continue and is considered bearish. 4. If, however, total open interest is declining along with declining prices, the price decline is being caused by discouraged or losing longs being forced to liquidate their positions. This action is believed to indicate a strengthening technical situation because the downtrend will probably end once open interest has declined sufficiently to show that most losing longs have completed their selling. Let's summarize these four points. 1. Rising open interest in an uptrend is bullish. 2. Declining open interest in an uptrend is bearish. 3. Rising open interest in a downtrend is bearish. 4. Declining open interest in a downtrend is bullish. Other situations where open interest is important. In addition to the preceding tendencies, there are other market situations where a study of open interest can prove useful. 1. Toward the end of major market moves, where open interest has been increasing throughout the price trend, a leveling off or decline in open interest is often an early warning of a change in trend. 2. A high open interest figure at market tops can be considered bearish if the price drop is very sudden. This means that all of the new longs established near the end of the uptrend now have losing positions. Their forced liquidation will keep prices under pressure until the open interest has declined sufficiently. As an example, let's assume that an uptrend has been in effect for some time. Over the past month, open interest has increased noticeably. Remember that every new open interest contract has one new long and one new short. Suddenly, prices begin to drop sharply and fall below the lowest price set over the past month. Every single new long established during that month now has a loss. The forced liquidation of those longs keeps prices under pressure until they have all been liquidated. Worse still, their forced selling often begins to feed on itself and, as prices are pushed even lower, causes additional margin selling by other longs and intensifies the new price decline. As a corollary to the preceding point, an unusually high open interest in a bull market is a danger signal. If open interest builds up noticeably during a sideways consolidation or a horizontal trading range, the ensuing price move intensifies once the breakout occurs. This only stands to reason. The market is in a period of indecision. No one is sure which direction the trend breakout will take. The increase in open interest, however, tells us that a lot of traders are taking positions in anticipation of the breakout. Once that breakout does occur, a lot of traders are going to be caught on the wrong side of the market. Let's assume we've had a three-month trading range and that the open interest has jumped by 10,000 contracts. This means that 10,000 new long positions and 10,000 new short positions have been taken. Prices then break out on the upside and new three-month highs are established. Because prices are trading at the highest point in three months, every single short position, all 10,000 of them, initiated during the previous three months now shows a loss. The scramble to cover those losing shorts naturally causes additional upside pressure on prices, producing even more panic. Prices remain strong until all or most of those 10,000 short positions have been offset by buying into the market's strength. If the breakout had been to the downside, then it would have been the longs doing the scrambling. The early stage of any new trend immediately following a breakout is usually fueled by forced liquidation by those caught on the wrong side of the market. The more traders caught on the wrong side manifested in the high open interest, the more severe the response to a sudden adverse market move. On a more positive note, the new trend is further aided by those on the right side of the market whose judgment has been vindicated and who are now using accumulated paper profits to finance additional positions. It can be seen why the greater the increase in open interest during a trading range, or any price formation for that matter, the greater the potential for the subsequent price move. Increasing open interest at the completion of a price pattern is viewed as added confirmation of a reliable trend signal. The breaking of the neckline, for example of a head and shoulders bottom, is more convincing if the breakout occurs on increasing open interest along with the heavier volume. The analyst has to be careful here. Because the impetus following the initial trend signal is often caused by those on the wrong side of the market, sometimes the open interest dips slightly at the beginning of a new trend. This initial dip in the open interest can mislead the unwary chart reader and argues against focusing too much attention on the open interest changes over the very short term. The story of volume and open interest rules. Let's summarize some of the more important elements of price, volume and open interest. 1. Volume is used in all markets. Open interest, mainly in futures. 2. Only the total volume and open interest are used for futures. 3. Increasing volume and open interest indicate that the current price trend will probably continue. 4. Declining volume and open interest suggest that the price trend may be changing. 5. Volume precedes price. 5. Changes in volume before price. 6. On balance volume, OBV, or some variation thereof, can be used to more accurately measure the direction of volume pressure. 7. Within an uptrend, a sudden leveling off or decline in open interest often warns of a change in trend. This applies only to futures. 8. Very high open interest at market tops is dangerous and can intensify downside pressure. This applies only to futures. 9. A build-up in open interest during consolidation periods intensifies the ensuing breakout. This applies only to futures. 10. Increases in volume and open interest help confirm the resolution of price patterns or any other significant chart developments that signal the beginning of a new trend. Blow-offs and selling climaxes. One final situation not covered so far that deserves mention is the type of dramatic market action that often takes place at tops and bottoms: blow-offs and selling climaxes. Blow-offs occur at major market tops and selling climaxes at bottoms. In futures, blow-offs are often accompanied by a drop in open interest during the final rally. In the case of a blow-off at market tops, prices suddenly begin to rally sharply after a long advance, accompanied by a large jump in trading activity and then peak abruptly. See figure 7.12. In a selling climax bottom, prices suddenly drop sharply on heavy trading activity and rebound as quickly. Refer back to figure 4.22c. Commitments of traders report. Our treatment of open interest would not be complete without mentioning the commitments of traders. Coat report and how it is used by futures technicians as a forecasting tool. The report is released by the Commodity Futures Trading Commission twice a month, a mid-month report, and one at month's end. The report breaks down the open interest numbers into three categories: large hedgers, large speculators, and small traders. The large hedgers, also called commercials, use the futures markets primarily for hedging purposes. Large speculators include the large commodity funds, who rely primarily on mechanical trend-following systems. The final category of small traders includes the general public, who trade in much smaller amounts. Watch the commercials. The guiding principle in analyzing the commitments report is the belief that the large commercial hedgers are usually right, while the traders are usually wrong. That being the case, the idea is to place yourself in the same positions as the hedgers and in the opposite positions of the two categories of traders. For example, a bullish signal at a market bottom would occur when the commercials are heavily net long, while the large and small traders are heavily net short. In a rising market, a warning signal of a possible top would take place when the large and small traders become heavily net long, at the same time that the commercials are becoming heavily net short. Net trader positions. It is possible to chart the trends of the three market groups and to use those trends to spot extremes in their positions. One way to do that is to study the net trader positions published in futures charts, published by Commodity Trends Service, PO Box 32309, Palm Beach Gardens, FL 33420. That charting service plots three lines that show the net trader positions for all three groups on a weekly price chart for each market going back four years. By providing four years of data, historical comparisons are easily done. Nick Van Nysse, the publisher of that chart service, looks for situations where the commercials are at one extreme and the two categories of traders at the other, to find buying and selling opportunities, as shown in figures 7.13 and 7.14. Even if you don't use the COT report as a primary input in your trading decisions, it's not a bad idea to keep an eye on what those three groups are doing. Open interest in options. Our coverage of open interest has concentrated on the futures markets. Open interest plays an important role in options trading as well. Open interest figures are published each day for put and call options on futures markets, stock averages, industry indexes, and individual stocks. While open interest in options may not be interpreted in exactly the same way as in futures, it tells us essentially the same thing: where the interest is and the liquidity. Some option traders compare call open interest to put open interest in order to measure market sentiment. Others use option volume. Put call ratios. Volume figures for the options markets are used essentially the same way as in futures and stocks. That is, they tell us the degree of buying or selling pressure in a given market. Volume figures in options are broken down into call volume, bullish, and put volume, bearish. By monitoring the volume in calls versus puts, we are able to determine the degree of bullishness or bearishness in a market. One of the primary uses of volume data in options trading is the construction of put-call volume ratios. When options traders are bullish, call volume exceeds put volume and the put-call ratio falls. A bearish attitude is reflected in heavier put volume and a higher put-call ratio. The put-call ratio is usually viewed as a contrary indicator. A very high ratio signals an oversold market. A very low ratio is a negative warning of an overbought market. Combine options sentiment with technicals. Options traders use open interest and volume put-call figures to determine extremes in bullish or bearish sentiment. These sentiment readings work best when combined with technical measures such as support, resistance, and the trend of the underlying market. Since timing is so crucial in options, most option traders are technically oriented. Conclusion. That concludes our coverage of volume and open interest. At least for now. Volume analysis is used in all financial markets. Futures, options, and stocks. Open interest applies only to futures and options. But, since futures and options are traded on so many stock market vehicles, some understanding of how open interest works can be useful in all three financial arenas. In most of our discussions so far, we've concentrated on daily bar charts. The next step is to broaden our time horizon and to learn how to apply the tools we've learned to weekly and monthly charts in order to perform long-range trend analysis. We'll accomplish that in the next chapter. End of chapter 7 That's the end of first part of this audiobook. If you find it useful, please like and subscribe. Thank you.