Technical Analysis Explained Page 10

  Major Technical Principle The longer the formation of any pattern takes and the more often it fails to break through its outer boundaries, the greater is the significance of the ultimate penetration.

  The time taken to complete a formation is important because of the amount of an asset changing hands and also because a movement in price beyond the boundaries of a pattern means that the balance between buyers and sellers has altered. When the price action has been in a stalemate for a long time and investors have become used to buying at one price and selling at the other, a move beyond either limit represents a fundamental change, which has great psychological significance. A great example of a very long rectangle is shown in Chart 8.3 for the CRB Composite.

  CHART 8.3 CRB Composite 1957–1982. This chart features a multiyear rectangle breakout that took place in 1972. There was no way of predicting the character of the rally, but the length of the rectangle indicated that something big was likely afoot.

  There was every probability that a breakout from such a pattern would be followed by a good move, but there was no indication that prices would rise so sharply over such a brief period of time.

  The depth of a formation also determines its significance. Consider the trench warfare analogy once more. If the opposing trenches are very close together—say, within 100 yards—this means that the victorious assault, when it comes, will be less significant than if the armies are separated by several miles, for in that case, the battles will have been much more intense and the victory that much greater. The same is true in the financial markets. The breeching of a wide trading range has far greater psychological significance than does a narrow one.

  Measuring Implications

  Most of the results obtained with technical analysis procedures do not indicate the eventual magnitude of a trend. Price patterns are the exception, since their construction offers some limited forecasting possibilities. Pretty well all price patterns obtain measuring objectives from their depth. The rectangle is no exception. Figure 8.9 shows a rectangle that has formed and completed a (distribution) top.

  FIGURE 8.9 Rectangle Top Measuring Objective

  The measuring implication of this formation is the vertical distance between its outer boundaries, i.e., the distance between lines AA and BB projected downward from line BB.

  In many cases, the price trend will extend beyond the objective. In really strong moves, it will travel in multiples of it. We can take the process a step further by stating that the various multiples of the objective itself can become important potential support and resistance areas in their own right. Time and again, these price objective areas turn out to be important support or resistance points. Unfortunately, there is no way to determine where the actual juncture point will be for any rally or reaction. This emphasizes the principle that in technical analysis there is no known way of consistently determining the magnitude of a price movement. It is only possible to speculate on the probability that a specific area will prove to be a support or resistance zone. Consequently, while this measuring formula offers a rough guide, it is usually a minimum expectation.

  Having established the fact that price patterns offer price objectives when completed, it is also important to revisit the options of arithmetic and logarithmic scaling covered earlier.

  If you recall, arithmetic scaling involves using the same vertical distance for equal point amounts so that the difference in space between 2 and 4 is the same as that between 20 and 22. This compares to ratio or logarithmic scaling, where the same vertical distance plots the same proportionate move. Thus, for example, one inch might represent a 20 percent price move at whatever level it takes place.

  The importance of using logarithmic scales whenever possible is shown in Figures 8.10 and 8.11. In Figure 8.10, the price traced out and broke down from a rectangle. Projecting the vertical distance between 200 and 100 downward gives an objective of 0, clearly a very unlikely possibility.

  FIGURE 8.10 Measuring Implications Using an Arithmetic Scale

  FIGURE 8.11 Measuring Implications Using a Logarithmic Scale

  On the other hand, Figure 8.11 uses the same projection based on a logarithmic scale. In this case, a more realistic objective of 50 is obtained.

  It is important to remember that market prices are a function of psychological attitudes toward fundamental events. Since these attitudes have a tendency to move proportionately, it makes sense to plot them on a scale that reflects proportionate moves equally. Clearly, this distinction has little effect on very shortterm (2 to 6 weeks) or intraday charts, but since you do not know exactly when it will, it’s definitely a good idea to set your charting software to ratio as a default.

  If a rectangle appears as a bottom reversal pattern, the measuring rules remain consistent with the example given for the distribution formation. The only difference is that we project the objective and multiples of the objective in an upward direction, not downward. The exact same principles also apply to continuation rectangles. Figure 8.12 shows an upside breakout from a rectangle that forms during a bullish trend.

  FIGURE 8.12 Upside Continuation Rectangle Measuring Objective

  Note in this case that the price does not immediately reach its upside objective, but does so after a small rally and reaction. This is why the objective is described by the term “ultimate.” Most people buy the breakout on the assumption that they will make more or less instant profits as the price moves straight to the objective, but that is not necessarily the case.

  Major Technical Principle A measuring objective is a minimum ultimate objective.

  In many cases, the price will move beyond the objective. In really strong moves, it will move in multiples of the objective, where the various multiples or the objective itself become important support and resistance areas.

  Confirmation of a Valid Breakout

  Price

  So far, it has been assumed that any move out of the price pattern, however small, constitutes a valid signal of a trend reversal (or resumption, if the pattern is one of consolidation). Quite often, misleading moves known as whipsaws occur, so it is helpful to establish certain criteria to minimize the possibility of misinterpretation. Conventional wisdom holds that you should wait for a 3 percent penetration of the boundaries before concluding that the breakout is valid. This filters out a substantial number of misleading moves, even though the resulting signals are less timely.

  This approach was developed in the first part of the twentieth century when holding periods for market participants were much longer. Today, with the popularity of intraday charts, 3 percent could represent the complete move and then some! I have no basic objection to the 3 percent rule for longer-term price movements in which the fluctuations are much greater. However, the best approach is a common sense one based on experience and judgment in each particular case. It would be very convenient to be able to say that anything over a specific percentage amount represents a valid breakout, but unfortunately, a lot depends on the time frame being considered and the volatility of the specific security.

  For example, electric utilities are very stable in their price action compared to mining stocks, where the volatility is far greater. Applying the same percentage breakout rule to both obviously doesn’t make sense. What constitutes a decisive breakout, where the odds of a whipsaw are considerably reduced, is then very much a matter of personal judgment based on experience, trial, and error. This judgment should take into consideration such factors as the type of trend being monitored, the volatility of the security, volume, and momentum characteristics.

  Another factor that can help early on in deciding if a breakout is valid is the fact that a good breakout should hold for several periods. For example, you may observe a decisive upside breakout from a rectangle on a daily chart, but if it cannot hold for more than one day above the breakout level, the signal is highly suspect. Often, the technical position is worse after such breakouts because breakouts that cannot hold indicate exhaustion and exhaustion moves a
re often followed by strong price trends in the opposite direction to that indicated by the (false) breakout.

  On entering any trade or investment based on a price pattern breakout, it is important to decide ahead of time what type of price action would cause you to conclude that the breakout was a whipsaw. In effect, this will be below a support level for an upside breakout and below a resistance zone for a downward one. For this you can draw on the information contained in Chapter 5 on support and resistance. An example of a false upside breakout might be a penetration of a previous minor low, a decline below a predetermined level from the breakout point, or the rupture of a minor up trendline. Some possibilities are featured in Figure 8.13.

  FIGURE 8.13 Identifying a Whipsaw Breakout

  A stop should then be placed below the support level. In this way, you will have calculated the loss you are willing to undertake and the point where the original premise for the trade, i.e., the breakout, is no longer operative. Failure to make such a decision ahead of time will mean that your decision to sell is more likely to be based on emotion and kneejerk reactions to news events than on a logical preset plan.

  Retracement Moves A great deal of the time, when the price breaks out from a pattern, the initial thrust is followed by a corrective move back to the upper or lower reaches of the formation, depending on the direction of the breakout. This is known as a retracement move, and it offers an additional entry point, often under substantially less emotional conditions. The retracement serves two functions. First, it helps to correct the excessive emotion associated with the breakout and brings people back to earth. From here, it is then possible for the new trend to extend on a sounder basis. Second, it acts as a test of the breakout. A downside retracement will find support at the breakout point and an upside retracement will find resistance in the lower boundary of the pattern as these two zones reverse their former roles.

  Retracements, then, represent normal price behavior, and although they can be frustrating, are nothing to get concerned about. Indeed, the breakout itself is often a volatile illiquid affair, as one side or the other heads for the entrance or exit, depending on its direction. As a result, orders are often executed with horrendous fills. Price activity during the retracement process, on the other hand, is relatively quieter. This means that buying or selling can be undertaken in a much more controlled environment. Figure 8.14 shows that it is often a good idea to wait for a retracement in a rising trend and buy as the price signals that the retracement is over.

  FIGURE 8.14 Buy on the Retracement Breakout

  Cancellations If the minimal objective proves to be the ultimate extension of the new trend, a substantial amount of accumulation or distribution, whichever is appropriate, will typically have to occur before prices can move in their previous direction. Thus, a 2-year rectangle might be completed and the downward price objective reached. Even though further price erosion does not take place, it is still technically necessary for a base (accumulation) of approximately the same size as the previous distribution (in this case, 2 years) to be formed before a valid uptrend can take place. An example is shown in Figure 8.15, where an upside breakout is cancelled by a downside one.

  FIGURE 8.15 Cancellation

  The word technically has been emphasized because that is not always the case, and there are lots of examples where large distribution formations have been cancelled by small ones and vice versa. That means if you can spot a cancellation, pay attention to the signal and look around at the other indicators to see if they agree. If so, go with the cancellation, as it’s probably telling the truth.

  Volume Considerations

  So far, we have just considered price in our analysis, but volume is an important independent variable that can help us obtain a more accurate reflection of crowd psychology. To quickly recap, volume typically goes with the trend, i.e., it expands with a rising trend of prices and falls with a declining one. This is a normal relationship, and anything that diverges from it should be considered a warning sign that the prevailing price trend may be in the process of reversing. Volume is always measured in relation to the recent past. Thus, heavy volume relates to volume 20 to 30 bars or so ago, not to volume, say, 10 years ago, where institutional changes may have permanently increased the level of activity.

  Major Technical Principle Volume is always measured relative to its recent past.

  In the case of the rectangle, and with most other patterns, it is normal for the trend of volume to contract as the formation develops. Activity may continue to fluctuate along with the price, but with the benefit of hindsight we would expect to see the various peaks and troughs of volume shrink as the pattern develops, along the lines of Figure 8.16. As it nears completion, disinterest prevails and volume often dries up.

  FIGURE 8.16 Volume Trend Shrinks as the Rectangle Is Being Formed

  The quality of an accumulation formation is certainly improved if volume expands on the upside break. Sometimes it is even possible to draw a trendline joining the lower volume peaks, as shown in Figure 8.16.

  It is this upward surge in trading activity that confirms the validity of the breakout because it flags the enthusiasm of buyers. A similar move on low and declining volume would be suspect and would result in its failure to move with the trend. An example is shown in Figure 8.17.

  FIGURE 8.17 Shrinking Volume on an Upside Breakout Is Bearish

  In this instance, volume definitely declines as the price is breaking out. Such action typically signals that prices are advancing more on a lack of sellers than strong enthusiastic buyers. As the price starts to slip, volume picks up noticeably, suggesting that this is happening because of selling pressure. It is a definite sign that increases the possibility that the breakout is a whipsaw.

  In many instances you will see charts where successful upside breakouts develop with no obvious change in activity, either on the upside or downside. Unfortunately, this is a fact of life. Thus, a good volume expansion is a desirable, but not necessarily a mandatory, condition for a valid breakout. It certainly increases the odds, but other indicators such as oscillators could also tip the balance. If volume declines on the breakout, as in Figure 8.17, this is more than a missing piece of positive evidence and is, actually, a negative factor. Figure 8.18 shows a downside breakout from a rectangle.

  FIGURE 8.18 Expanding Volume on a Downside Breakout Is Bearish

  The same shrinking volume characteristics during the development of the pattern are present as for the bullish variety. However, volume characteristics on the breakout are less critical. This is because it is normal for it to contract as prices decline. Thus, contracting volume on a breakdown is perfectly normal. What is not typical, though, is for it to expand on a downside move. This in itself suggests that sellers are more motivated and therefore adds a negative flavor to the pattern. More often than not, prices will reverse and put on a small recovery or retracement rally following the downside breakout (Figure 8.19).

  FIGURE 8.19 Volume Should Shrink on the Retracement Rally

  This advance is invariably accompanied by declining volume, which itself reinforces the bearish indications. It is halted at the lower end of the rectangle, which now becomes an area of resistance. The same idea of declining volume should accompany a retracement move that follows an upside breakout. Figure 8.20 shows an example where both price volatility and volume shrink dramatically.

  FIGURE 8.20 Narrow Rectangle and Nonexistent Volume Are Often Followed by a Sharp Move

  This combination indicates an extremely fine balance between buyers and sellers that takes place over an extended period. Normally, a price objective is determined by the depth of the formation. In this case, though, the finely balanced supply/demand situation is usually followed by a far greater and sharper move than that indicated by the normal measuring techniques. Figure 8.20 dramatizes a sharp downside breakout, but the principle of rapidly declining volume followed by a huge expansion applies equally as well to an upside breakout. In this instance, volu
me typically explodes as we move from a situation in which there is virtually no interest by either party to one in which buyers cannot get enough of the security at any price. Such are the ingredients for the start of a dramatic rally. An example is shown in Chart 8.4 of the U.S.-traded St. Jude Medical, where a very narrow rectangle developed with a dramatic drop in volume. When activity expanded, a short but sharp rally followed.