Technical Analysis Explained Page 24

  CHART 15.23 Gold Trust ETF, 2011–2012 the ADX versus a DI Differential Indicator

  Low readings in the ADX indicate a lack of directional movement. These these can be helpful as well when it is fairly clear that a new rising trend of directional movement from such a benign level is under way. In this respect, the differential indicator traced out a reverse head and shoulders in the late summer of 2012 just as the ADX was crossing above its MA from a subdued level. The low ADX reading told you there was no directional movement and to be prepared for some. In addition, the breakout from the base in the differential and trendline violation in the price said it would be an upward one.

  Summary

  1. The KST can be constructed for any time frame, from intraday to primary.

  2. It is calculated from the smoothed ROC of four time spans, each of which is weighted according to the length of its time span.

  3. Long-term, short-term, and intermediate KSTs can be combined into one chart to reflect the market cycle model.

  4. The KST lends itself to numerous momentum interpretive techniques.

  5. The KST can successfully be applied to relative strength analysis.

  6. The Special K is a summation of the short-term, intermediate, and long-term KSTs and can be useful for identifying short-term and long-term trend reversals.

  7. In most situations, the Special K peaks and troughs very closely to primary-trend turning points.

  8. Trend reversals in the Special K are signaled by trendline violations, moving-average crossovers, and peak/trough progression reversals.

  9. The +DI and –DI measure positive and negative short-term direction. They can be smoothed to eliminate whipsaws and can be differentiated to result in a timely oscillator.

  10. When the raw or smoothed DIs cross, they trigger buy and sell momentum signals.

  11. The ADX measures the directional movement of a trend.

  12. A rising ADX indicates an increase in directional movement and vice versa.

  13. When the ADX reverses direction from a high reading, the prevailing trend is likely to change.

  16 CANDLESTICK CHARTING

  Candle Construction

  The candlestick form of charting began to gain popularity in the 1990s.1 This method originated in Japan several centuries ago and basically offers the same information as bar charts. The difference is that candlestick charts can often make it easier to spot certain technical phenomena not readily apparent with a quick glance at a bar chart. Bar and candlestick charts are compared in Figures 16.1 and 16.2. Although candlesticks can be plotted for any period, from minute to monthly, I will use the term “daily” as a generic reference in this chapter to eliminate repetition.

  FIGURE 16.1 Bar versus Candle Charts

  FIGURE 16.2 Bar versus Candle Charts

  Candlestick charts can only be plotted for markets in which opening prices as well as closes, highs, and lows are known. One disadvantage is that they take up a lot of horizontal space, which limits the amount of data that can be physically displayed. Fortunately, trend-reversal signals tend to be very short term in nature, with their effects generally lasting for a few days and rarely more than three weeks. Candlestick charts offer indications of both reversal and continuation phenomena, just as bar charts do. Some examples in this chapter demonstrate these phenomena in candlestick formations. They really come into their own in the identification of shorter-term reversals and continuation situations.

  Candlesticks are certainly no magic wand, but they are unquestionably a useful technical tool for short-term traders. They consist of a vertical rectangle with two lines spiking up and down. The vertical rectangle is known as the real body and encompasses the trading activity between the opening and closing prices (Figure 16.3).

  FIGURE 16.3 Candle Construction

  For example, if the opening price is higher than the closing price, it will be recorded at the top of the real body and the closing price at the bottom. The vertical line above the real body measures the distance between the high of the day and the higher of the opening or closing price. The lower line represents the distance between the low of the day and the lower of the opening or closing price. Days when the close is higher than the opening are represented by transparent (white) real bodies; days when the opening is higher than the close are displayed by a solid (black) real body (Figure 16.4). Even though candlesticks can be plotted for any period in which information is available, I use days in the example because daily candlestick charts are the most common.

  FIGURE 16.4 Real Bodies

  Major Technical Principle In candlestick charting, the greatest emphasis is given to the opening and closing prices and the trading range between them.

  The thin vertical lines that protrude from the real body reflect the high and low for the day. These are known as upper and lower shadows or wicks. Since the closing and opening prices can be identical, or identical with the high or low, a number of possible combinations need to be represented. Some of them are shown in Figure 16.5. Candlesticks provide essentially the same information as bar charts, but their more pronounced visual representation of the material enables technicians to identify characteristics that are less obvious on bar charts. Certain phenomena illustrated in bar charts have been given their own names, such as “key reversal days” or “island reversal days.” Likewise, with candlestick charts, because of the large number of potential variations for both individual days and price formations encompassing several days, it has been common practice to give exotic names to the various possibilities.

  FIGURE 16.5 Selected Candle Formats

  Basic Candlestick Pattern Building Blocks

  The candlestick patterns in Figure 16.6 are among the most essential individual candlestick lines for building candlestick patterns. A doji is a trading session where the opening and closing prices either are the same or very close to each other. When dojis appear in trading ranges, they reflect an environment where buyers and sellers are temporarily in balance and are, therefore, of little significance. However, when they develop after an advance or decline, the appearance of a more balanced state between supply and demand is a vital clue that the trend may be about to change, since this state of implied balance follows a period in which either buyers (rally) or sellers (decline) were previously in control.

  FIGURE 16.6 Spinning Tops

  Finally, there is a spinning top. Small real bodies characterize them, where the shadows can be short or long. It is the size of the real body, rather than the shadow’s size, that is important in identifying a spinning top. Spinning tops are not important when they appear in trading ranges, but they are significant when they develop as part of a price pattern, since they represent a battle between the bulls and the bears. Spinning tops indicate indecision, where participants cannot agree on whether prices should rally or react. When they appear after a prolonged rally or reaction, it is a sign that upside or downside momentum is dissipating. Putting it another way, we could say that in previous sessions, buyers or sellers had the upper hand, but the spinning top tells us the fight is more evenly matched. Thus, another small change in the balance between supply and demand could tip the price trend the other way. This is why a spinning top is an initial sign a trend may be in the process of reversing. Only when this is confirmed by other price action, which we shall get into later, should you take action.

  Figure 16.6 includes an umbrella line. The concept behind umbrella lines is that the opening and closing prices develop close to the high of the day. The real body in this case more closely resembles a square than a rectangle. Umbrellas tend to be bullish after a decline and bearish following an advance. If they develop within the confines of a trading range, they have no real significance.

  Belt-Hold Lines (Yorikiri)

  A bullish belt hold (long white line in Figure 16.7a) is a one-candlestick pattern consisting of a long white candlestick in which the price opens on the session low and then works its way higher throughout the session. The price does
not have to close at the high, but the longer the real body, the more positive the candlestick. Also, if a belt hold has not appeared on the chart for quite a while, it is an unusual phenomenon, so, it gains in importance when it does appear. This is because traders are making a very strong statement about their feelings toward the market with a belt hold, compared to the smaller candlesticks that were previously the norm. Just think of a crowd murmuring and then a loud voice comes from within the crowd. It is obviously a person who wants to be heard. The belt hold following a long period of smaller candlesticks amounts to the same thing—it’s a 1-day pattern that says loudly, “Listen to me because I am telling you the short-term trend has changed.”

  FIGURE 16.7 Belt Holds (Long White/Black Lines)

  A bearish belt hold (the long black line in Figure 16.7b) is the opposite. It is a long black candlestick in which the price opens at the high and then works its way lower as the session progresses. Belt holds are often important pivotal days, since the high and low occasionally act as support and resistance areas in subsequent price action. The halfway point of the real body of a belt hold also should be monitored for a possible price reversal during later price swings.

  The upper and lower areas of belt holds are potential future support/resistance levels. An example is shown in Chart 16.1.

  Chart 16.1 Ciena

  Candlestick patterns basically fall into two broad categories, reversal and continuation, so we will split our discussion into these respective parts, starting with the more interesting reversal phenomena. Candlesticks can be applied to any time frame, though when they appear on intraday charts they do not have as much significance as on daily or weekly charts. Their effect, like that of bar charts, should only be expected to last for between 5 and 10 candles. Thus, it would be reasonable to expect a candlestick pattern on an hourly chart to last for 5 to 10 hours and on a monthly chart for 5 to 10 months and so forth.

  Reversal Phenomena

  Hammers and Hanging Men (Takuri and Kubitsuri)

  These formations (Figures 16.8 and 16.9) have probably gained more notoriety than all the others because of their imposing titles. A “hanging man” is an umbrella line that develops after a rally. The shadow should be at least twice the size of the real body. It looks rather like the body of a man with dangling legs and, as its name implies, is a bearish pattern. If a hanging man appears after a prolonged up move, it should be treated with respect, especially if it occurs after a gap. A hanging man can be identified by the fact that the shadow, or wick, is at least twice the height of the real body. The color of the body is not important.

  FIGURE 16.8 Hanging Man

  FIGURE 16.9 Hammer

  A “hammer” is identical to a hanging man but occurs after a market decline, when it is a bullish sign. It gets its name from the idea that the price is “hammering out” a bottom. In effect, it represents the kind of trading day when the price temporarily slips quite sharply, for there is a “run” on the selling stops. Nevertheless, the technical position is sufficiently constructive to cause buyers to come into the market and push the price back up toward or above the opening level. It is always better to see some confirmation. In the case of a hanging man, this confirmation could take the form of a long, black candlestick, as indicated in Figure 16.8. An example of a hammer is shown in Chart 16.1 for Ciena. Note how the open and the close develop well above the day’s low, thereby indicating seller exhaustion following a sharp setback.

  Dark Cloud Cover (Kabuse)

  In real life, dark clouds (Figure 16.10) hint at the possibility of rain, so a “dark cloud” candlestick formation implies lower prices. Its bearish connotations are most pronounced during an uptrend or in the upper part of a congestion zone. It is a form of key reversal, since the price closes down on the day after a gap higher opening. It consists of 2 days’ price action. The first is a strong, white real body, and the second is a black body in which the open develops above the upper wick of the white candlestick and the close occurs in the lower half of the previous white real body. An example is shown in Chart 16.2. Normally these patterns develop after a sharp rally where there are plenty of traders willing to take profits. This one also qualifies as an engulfing pattern (described later).

  FIGURE 16.10 Dark Cloud Cover

  Chart 16.2 S&P ETF

  Piercing Line (Kirikorni)

  This pattern (Figure 16.11) would be more aptly named “sunny sky” because it is the exact opposite of the dark cloud and is, therefore, bullish. It is important to note whether the second day’s white body closes more than halfway above the previous body, with an opening price that traded below the lower wick of the previous black candlestick. Chart 16.3 shows a classic example at the October 2011 low in the S&P ETF, the SPY. We also see another example earlier that barely qualifies under the rule that states that the black candlestick should close more than halfway below the real body of the previous white candle. Chart 16.4 also shows a couple more instances of piercing white lines.

  FIGURE 16.11 Piercing White Line

  CHART 16.3 S&P ETF

  Engulfing Pattern (Tsutsumi)

  This formation (Figures 16.12 and 16.13) develops significance after a prolonged price move. It is characterized by two consecutive, relatively shad-owless, real bodies in which the real body of the second day “engulfs” that of the first. It is bullish in a downtrend, when the second day is a white body, and bearish in an uptrend, when it appears as a black one. We are treated to a bearish engulfing pattern for the Global X Silver Mine ETF in Chart 16.4. Even though this was a classic pattern, there was no way to forecast the enormity of the ensuing decline. A bullish engulfing pattern appears in Chart 16.5.

  FIGURE 16.12 Bullish Engulfing Pattern

  FIGURE 16.13 Bearish Engulfing Pattern

  CHART 16.4 Global X Silver Miners ETF, 2011–2012

  CHART 16.5 Echostar Communications

  Stars (Hoshi)

  Stars are common phenomena in candlestick charts and come in four different reversal varieties. They are combinations of wide real bodies and spinning tops. The morning star (Figure 16.14) heralds a new day (up move) and is bullish.

  FIGURE 16.14 Bullish Morning Star

  It consists of two long real bodies separated by a spinning top. The star is represented by the spinning top, which is made on a gap. The third body should be white and should result in a closing price being more than halfway up the body of the first. The evening star (Figure 16.15) is a precursor of night. It has the opposite characteristics and implications of a morning star.

  FIGURE 16.15 Bearish Evening Star

  An example appears in Chart 16.3 for the S&P ETF in September 2012. Ideally, I would have liked to see a larger white real body as the first candlestick in the pattern, but it worked nevertheless. Candlestick patterns, like all technical phenomena, can and do fail from time to time, and stars are no exception. In this respect, Figure 16.16 shows a failed bearish evening star, as the white candlestick to the right takes the price above the spinning top. A cancellation of a morning star would develop in exactly the opposite way, with a black real body taking the price below the spinning top.

  FIGURE 16.16 Cancelled Evening Star

  A bearish evening doji star (Figure 16.17) bullish occurs after a lengthy rally. It consists of a gap and a doji line. An example appears in Chart 16.4 and a bullish morning doji star in Figure 16.18.

  FIGURE 16.17 Bearish Evening Doji Star

  FIGURE 16.18 Bullish Morning Doji Star

  A particularly wide trading range, where the opening and closing are more or less identical, is known as a long-legged doji. An example is shown in Figure 16.19

  FIGURE 16.19 Long-Legged Doji

  Where it appears after a long white candlestick, it can be quite ominous.

  A shooting star (Figures 16.20 and 16.21) is like a short-term top. The daily price action experiences a small gap, where the real body appears at the end of a long wick or upper shadow. We see a couple of examples of bearish shootin
g stars in Chart 16.5. Late September 2011 witnessed a classic shooting star, with two relatively large real bodies sandwiching a much smaller one. The October pattern, on the other hand, saw two relatively small real bodies surround an even smaller one, and represents a bit of a stretch. The same comments could be applied to the shooting star in Chart 16.4. A bullish shooting star is also featured in Chart 16.6.