Technical Analysis Explained Page 26
The decision about unit size (and thus the degree of price change required to trigger a new column of O’s or X’s) is essentially based on personal judgment. It is determined by the price range and degree of volatility of the indicator, stock, or market under consideration. Reducing the size of the units (figures) increases the detail of the price movement portrayed. Making the unit larger expands the base of data, that can be included, but this limits the number of fluctuations that can be illustrated (see Chart 17.1). Following a market with bar or line charts on a daily, weekly, or monthly basis corresponds to keeping several point and figure charts using various unit sizes.
CHART 17.1 Gold Price $5 and $2 Reversals. These two charts show the gold price plotted on $5 and $2 reversals. The trendlines are self-explanatory. Note that the $5 chart captures 10 years of history very concisely. On the other hand, the 2-point reversal chart, which covers March to November 1982, offers far better detail.
Point and figure charts are plotted on an arithmetic scale. If drawn on paper, they would have traditionally been constructed with 8, 10, or 12 squares to the inch. Occasionally, point and figure charts are plotted on a semilogarithmic or ratio scale, though this is not the norm, because price objectives are calculated in a different way than those on regular charts with a time scale.
Data published in the financial press covering the high, low, and close for specific stocks are not suitable for accurate point and figure charts. For example, if a $15 stock has an intraday price range of $1½, it is impossible to know for point and figure purposes the actual course of the stock from 14½ to 16. It could have risen from 14½ to 16 in one move, which for a ½-point chart would have been represented by three rising X’s. Alternatively, it might have moved from 14½ to 15½, back to 14½, and then to 16, which would have resulted in two X’s, two O’s, and then a column of three X’s. The character of the rally has a very important bearing on the appearance of a point and figure chart.
When dealing with data published in this form, it is better to use larger units so that intraday fluctuations do not distort the chart unduly. If more detail is required, the data should be purchased from a source that publishes intraday price movements. Charting packages featuring intraday data that have point and figure options are not affected by this problem.
Accepted rules for plotting point and figure data where the actual prices on the tape are not known are as follows:
• If the opening price is closer to the high than the low, assume that the course of prices is open, high, low, and close.
• If the opening price is closer to the low, assume open, low, high, and close.
• If the opening price is also the high, assume open, high, low, and close.
• If the opening price is also the low, assume open, low, high, and close.
• If the opening price is the low and the closing price is the high, assume open, low, close, and high.
• If the opening price is the high for the day and the close is the lowest price, assume open, high, close, and low.
Interpreting Point and Figure Charts
General
Since point and figure charts do not include volume, moving averages (MAs), or time, price action is the only element to be examined. In this respect, the basic principles of bar chart analysis are applied. There are certain disadvantages to using point and figure charts; for example, key reversal days, islands, gaps, and other such formations do not show up. On the other hand, if properly constructed, these charts represent all important price swings, even on an intraday basis. They effectively emphasize important support and resistance areas. For example, on a weekly bar chart, a single bar representing a weekly price action can take up only one line. However, if there was considerable volatility during the week in which support and resistance were each tested three or four times, this would most likely show up on a point and figure chart as a congestion area. As a result, the importance of these levels would be drawn to the attention of the technician, who would then be in a good position to interpret the significance of any breakout that might develop.
Point and figure patterns are similar in nature to those of price patterns and may be of the continuation or reversal type. The most common ones are shown in Figure 17.2. Head-and-shoulders (H&S) and inverse H&S patterns, double tops and bottoms, and rounding tops and bottoms can easily be recognized as the point and figure equivalent of regular bar or close-only price formations, discussed previously. Most of the price patterns shown in Figure 17.2 are explained in Chapter 5.
FIGURE 17.2 Point and Figure Price Patterns (Study Helps in Point and Figure Techniques)
The Count Method
Chapter 5 pointed out that the minimum downside projection from an H&S top is derived by projecting the vertical distance from the top of the head to the neckline downward at the point of breakout. In point and figure charting, the width of the pattern is used to determine the measuring objective, which is again projected from the breakout point. No one to my knowledge has thus far satisfactorily explained why this principle appears to work. It seems to be based on the idea that lateral and vertical movements are proportional to each other on a point and figure chart. In other words, the more times a price has undergone price swings within two given levels (as dictated by the price pattern), the greater the ultimate move is likely to be once the breakout has taken place. On a point and figure chart, the dimensions of the consolidation or reversal pattern can be easily discerned by adding up the number of boxes and projecting the number downward or upward, depending on which way prices break out.
The problem with the count method is that formations with irregular outlines can generate confusion about where the count should begin. The best approach is to select an important horizontal line in the formation, measure across it, and add (or subtract) the number of boxes in the line to (or from) the level of the line.
Price projections for point and figure formations are by no means 100 percent accurate in all situations. In general, upside projections are likely to be exceeded in bull markets, and downside projections surpassed in bear markets. Projections that are made counter to the prevailing trend have a tendency not to be achieved, such as a downside projection in a bull market. Chart 17.2 shows a couple of examples of the count method in action.
CHART 17.2 Honeywell (.50 × 1). This chart features a number of price formations for Honeywell using a .50 × 1 combination. Note that the measuring objective from the base on the left was reached almost to the dollar. The H&S top that followed offered a nice sell signal as the neckline was penetrated. The objective in this case called for the price to fall back to its previous low. As it turned out, this was exceeded. Note how the subsequent rally found resistance in approximately the same area as the objective. Finally, we see a nice trendline break in the right-hand side of the chart.
Trendlines on Point and Figure Charts
It is possible to construct trendlines on point and figure charts by joining a series of declining peaks. Up trendlines are drawn by connecting a series of rising lows, and horizontal trendlines are created by joining identical support or resistance levels. The same principles of interpretation discussed in Chapter 8 apply to trendlines drawn on point and figure charts. The trendline takes its significance from a combination of length, the angle of descent or ascent, and the number of times it has been touched. Misleading or whipsaw signals occur occasionally. However, if a carefully chosen reversal amount is used as a filter in the construction of the chart, such whipsaws can be kept to a minimum. Another possibility would be to draw a parallel line one box above (or below) the actual trendline as a filter and use this as the signal to buy (or sell). Although some timeliness is clearly lost with this type of approach, it does offer some protection from misleading price moves.
Major Technical Principle The fundamental difference between price projections based on point and figure charts and those based on bar or close-only charts is that the measuring formula of point and figure charts is derived fro
m a horizontal rather than a vertical count.
It is also possible to construct oscillators and plot them underneath point and figure charts. Since time is ignored in the point and figure charts, oscillators will appear differently than on regular charts where the time scale is plotted for each unit (hour, day, week, and so on). An example using a 14-period relative strength indicator (RSI) is shown in Chart 17.3.
CHART 17.3 Boeing (1 × 1) and an RSI. This chart of Boeing shows that it is possible to combine an oscillator with a point and figure chart. The joint breakout by the price and RSI offered a timely buy signal on June 16.
Summary
• Point and figure charts measure only one dimension: price.
• Point and figure charts are constructed from columns of X’s and O’s, known as figures, which represent a specified, predetermined price movement.
• Point and figure charts often point up support/resistance zones better than bar charts because they emphasize the number of price swings that take place within a given congestion area.
• Point and figure charts are interpreted similarly to bar charts, the main exception being the measuring formula, which is achieved by the principle of the count.
18 MISCELLANEOUS TECHNIQUES FOR DETERMINING TRENDS
We are going to start off with the concept of proportion, which is concerned with offering some ideas on the possible magnitude of a price move. I deliberately emphasize the word possible because there is no known technique that can consistently forecast magnitude or duration. These techniques should be used only as an indication of the probable extent of the move, not as the basis of an actual fore-cast. Perhaps the simplest way to explain the principle of proportion is to say that crowd psychology, as reflected in market prices, has a tendency to move in specific proportional amounts that have a habit of repeating, but unfortunately not in a predictable pattern. Thus, we could say that stock prices have a habit of doubling and that may have happened three times in the last 20 years. However, there is no guarantee that they will do so in the current cycle. All we can do is observe when this happens and say that this is a good place to anticipate a reversal. Our decision, though, must be based on a consensus of indicators of which the principle of proportion is one. In this instance, the doubling would be an alert to look more closely at the balance of the evidence.
Proportion
The law of motion states that for every action, there is a reaction. Price trends in financial markets are really a reflection of changes in crowd psychology. The measuring implications of price patterns, trendlines, moving averages (MAs), and envelopes, which were discussed earlier, are examples of proportion in practice.
Support and resistance levels can help offer some ideas of just where a price trend may be temporarily halted or reversed. The principles of proportion can do the same thing, but they go much further.
For example, when a security price is exploring new, all-time-high ground, there is no indication of where a resistance level may occur because no transactions have taken place there. In such cases, the concept of proportion offers a clue to potential juncture points.
Perhaps the best-known principle of proportion is the 50 percent rule. For instance, many bear markets, as measured by the Dow Jones Industrial Average (DJIA), have cut prices by half. For instance, the 1901–1903, 1907, 1919–1921, and 1937–1938 bear markets recorded declines of 46, 49, 47, and 50 percent, respectively. The first leg of the 1929–1932 bear market ended in October 1929 at 195, just over half the September high. Sometimes, the halfway mark in an advance represents the point of balance, often giving a clue as to the ultimate extent of the move in question or, alternatively, indicating an important juncture point for the return move. Thus, between 1970 and 1973, the market advanced from 628 to 1,067. The halfway point in that rise was 848, or approximately the same level at which the first stage of the 1973–1974 bear market ended.
By the same token, rising markets often find resistance after doubling from a low; the first rally from 40 to 81 in the 1932–1937 bull market was a double.
The 50 percent mark falls halfway between the one-third and two-thirds retracement described in the discussion of Dow theory. These one-third and two-thirds proportions can be widely observed in all financial markets, and also serve as support or resistance zones. Ratio scale charts are helpful in determining such points, since moves of identical proportion can easily be projected up and down.
Chart 18.1 shows the 2000–2002 bear market. Note how the March 2001 rally retraced 50 percent of the bear market’s first downleg. The next advance retraced a little more than 33 percent of the primary trend drop up to that point. Finally, you can see how the area of the 9/11 low proved to be resistance for the July/August 2002 advance.
CHART 18.1 S&P Composite, 1999–2003 Retracement Moves
It is not possible to project which proportion will result from a specific move. However, these swings occur with sufficient consistency to offer possible reversal points at both peaks and troughs. If general market conditions and additional technical analysis of the price are consistent, there is a good chance that the projections based on this approach may prove accurate.
Remember, technical analysis deals with probabilities, which means that forecasts solely based on this method should never be undertaken. If you are making a projection based on the rules of proportion, it is always a good idea to see whether the projection corresponds to a previous support or resistance point. If so, the odds will be much higher that this zone will represent a reversal point, or at least a temporary barrier. When a market is reaching new, all-time-high ground, another possibility is to try to extend up trendlines. The point at which the line intersects with the projection using the rules of proportion may well represent the time and place of an important reversal. Experimentation will show that each market, stock, or commodity has a character of its own, some lending themselves more readily to this approach, others not at all.
Chart 18.2, featuring Amazon, shows some retracement moves and does some 50 percent projections into new high territory. The full decline between 1999 and 2002 flagged by the thick arrow sports a 0 percent because at that point there is no retracement. The 50 percent mark halts the initial rally and forms support in 2008. The 150 percent level becomes a pivotal point, not as a resistance, but as support for subsequent declines.
CHART 18.2 Amazon, 1998–2012 Retracement Moves
Major Technical Principle Always use projections using the principles of proportion in conjunction with other indicators.
Speed Resistance Lines
This concept incorporates the one-third and two-thirds proportions, but instead of incorporating them as a base for a probable price objective, uses them in conjunction with the speed of an advance or a decline. This concept was developed by the late, great Edson Gould, one of the finest technical minds of all time.
During a downward reaction, a price may be expected to find support when it reaches a line that is advancing at either two-thirds or one-third of the rate of advance from the previous trough to the previous peak. This is illustrated in Figure 18.1.
FIGURE 18.1 Speed Resistance Line (Bull Retracement)
In examples a and b, A marks the trough and B the peak. The advance from A to B is 100 points and takes 100 days, so the speed of the advance is 1 point per day. A one-third speed resistance line will advance at one-third of that rate (that is, a third of a point per day), and a two-thirds line will move at two-thirds of a point per day.
A rally or decline is measured from the extreme intraday high or low and not the closing price. In order to construct a one-third speed resistance line from example a, it is necessary to add 33 points (i.e., one-third of the 100-point advance) to the price at A and plot this point directly under B. In this case, A is 100 points, and so a plot is made at 133 under B. This point is then joined to A and the line extended to the right-hand portion of the graph. Similarly, the two-thirds line joins A and the 166 level on the same date as B. If the cha
rt were plotted on a ratio scale, the task would be much easier. All that would be required would be a line joining A and B (this is shown in example b). The angle of ascent—in this case, 30 degrees—would then be recorded. Two lines at one-third (10 degrees) and two-thirds (20 degrees) of this angle are then drawn. Figure 18.2 illustrates the same process for a declining market. Once constructed, the speed resistance lines act as important support and resistance areas.
FIGURE 18.2 Speed Resistance Line (Bear Retracement)
More specifically, the application of these lines is based on the following rules:
1. A reaction following a rally will find support at the two-thirds speed resistance line. If this line is violated, the support should be found at the one-third speed resistance line. If the price falls below its one-third line, the probabilities indicate that the rising move has been completed and that it will decline to a new low, possibly below that upon which the speed resistance lines were based.