Technical Analysis Explained Page 27
2. If the price holds at the one-third line, a resistance to a further advance may be expected at the two-thirds line. If it moves above the two-thirds line, a new high is likely to be recorded.
3. If the price violates its one-third line and then rallies again, it will find resistance to that rally at the one-third line.
4. Rules 1 through 3 apply in reverse for a declining market.
Chart 18.3 shows the application of these rules in the marketplace, where A and B mark the points at which the lines are anchored, since these represent the first intermediate turning points in their respective bear and bull markets. Obviously, with the benefit of hindsight, it is easy to spot these turning points, but in reality, it is likely to be several weeks before they could be identified. Only then would it be possible to use the lines as potential support/resistance levels. These are flagged with the small arrows. It would have been possible to come up with examples where the lines served more often as pivotal points, but the situation in Chart 18.3 is, unfortunately, more the rule than the exception.
CHART 18.3 NASDAQ 100, 2007–2012 Speed Resistance Lines
Fibonacci Fans
Fibonacci fan lines are displayed by first drawing a line between two extreme points: a high and low (vice versa in a declining market). An invisible vertical line is drawn through the second extreme point. Three lines are then constructed from the first extreme point (the low) passing through the invisible vertical line with their slopes at the Fibonacci levels, usually 38.2 percent, 50.0 percent, and 61.8 percent. These lines indicate potential areas of support and resistance. In Chart 18.4, the thick arrow joins the 2009 low in the S&P Composite to its first intermediate high. The Fibonacci fan lines at 38.2, 50, and 61.8 percent flag the three retracement levels, as at the vertical line. It is once again very important to emphasize that such pivotal points do not always appear as conveniently as in the chart. This emphasizes the idea already put forward that one should always use these techniques along with other indicators. They should never be used on their own to make a prediction because of their lack of reliability.
CHART 18.4 S&P Composite, 2009–2012 Fibonacci Fan Lines
Gann Fans
Gann lines are named for the early twentieth-century commodity trader W. D. Gann. They come in three forms: Gann lines, fans, and grids. The most practical appears to be the fan approach. The concept and application are very similar to the speed resistance lines discussed earlier. Gann’s idea was that specific geometric patterns and angles had unique characteristics for the prediction of price turning points. Essential to this approach was a balance between time and price. Thus, a 45-degree angle offered a perfect balance between price and time. That could only be achieved if the distance on the chart is the same for price and time, thus mandating an arithmetic scaling on the price axis. An example is shown in Chart 18.5, where the nine Gann recommended angles are plotted.
CHART 18.5 Advanced Micro Circuit, 2000 Gann Fan Lines
The following table reflects the rise (price increase) over run (time difference). As way of explanation 12 × 1 rise run means that the price increases twice as fast compared to the time taken for a run of 1, and so forth.
Chart 18.6 shows Gann fans. In this instance, the central line connects the high with the December low and the rise/run proportions are the same; the center line reflects a 1 × 1, the upper line reflects an 8 × 1, and so forth.
CHART 18.6 Advanced Micro Circuit, 2000–2001 Gann Fan Lines
However, because the time and price distances are not the same, the lines are at different angles. The principles of interpretation are similar, in that it is assumed that when one line is penetrated, the price will find resistance at the next one if it is rising, or support in the case of a decline. Thus, the lines are continually reversing their support/resistance functions. See how the initial rally finds resistance at the 2 × 1 line. This line is subsequently penetrated on the way up, but acts as support for the next two reactions. Once again, there are far more exceptions than those reversal points that make up the rules. This means, of course, that Gann fans should be used as a place for anticipating a reversal, depending on what the other indicators are saying.
Ichimoku Cloud Charts
The Components
A relatively recent introduction to the Japanese technical arsenal is the Ichimoku cloud, also known as Ichimoku Kinko Hyo. Literally translated, it means “at one glance balance bar chart.” The cloud and its ancillary indicators provide trading signals through the ability to identify trend direction, as well as indicating potential support and resistance areas. Goichi Hosoda, the creator of this approach, argues that traders adopting it can immediately identify the trend and isolate potential signals within it. At first glance, the cloud approach appears complicated, almost intimidating, but when explained, its interpretation is relatively straightforward.
The first thing to understand is that the relationship between the price and the cloud identifies basic uptrends and downtrends, and the relationship between two other indicators in the system generates short-term buy and sell signals under that context.
Altogether, there are five moving parts to the system. They have been labeled in Chart 18.7.
CHART 18.7 Microsoft 2012 Ichimoku Cloud
To simplify the explanation, we start off in Chart 18.8 by focusing on two indicators: the conversion line (also called the turning line) and the base line (also called the standard line). The conversion line is calculated as the midpoint of the 9-day high-low range. The default setting is nine periods, and the formula would be (9-period high + 9-period low)/2. The base line uses the same approach, but this time, the high over 26 periods is added to the low over that same period. The total is once again divided by two. The Japanese term for the conversion line is Tenkan-sen and for the base line, it is Kijun-sen. The relationship between these two indicators forms the basis for short-term buy and sell signals, as well as the faster of the two cloud boundaries. Let’s consider the cloud first and then talk about the signals.
CHART 18.8 S&P Composite ETF, 2011–2012 Ichimoku Conversion and Base Line with Lagging Span
The boundary derived from the conversion and base line relationship is the cloud (leading) span A or 1 (senkou span A). This indicator is calculated by adding the value of the conversion line to that of the base line and dividing by two. It uses the word leading in its description because the result is plotted 26 periods into the future as shown in Chart 18.9.
CHART 18.9 S&P Composite ETF, 2011–2012 Ichimoku Leading Spans
The second cloud border, cloud (leading) span B or 2 (senkou span B) is calculated by adding the 52-period high to the 52-period low and dividing by two. The result is also plotted 26 periods in advance. In Chart 18.9, the 52-period high/low is calculated at point X and the result is plotted at point Y. Since the high/low calculation returned a low number at X, cloud span B was plotted at quite a distance below the prevailing price at Y in late March 2012 because the actual price was much higher. The fifth moving part is the lagging line, which is the closing price shifted back 26 days. In the vast majority of situations, this series crosses the cloud after the price and represents a confirming signal that the trend has changed.
The parameters outlined earlier are the recommended default ones, but there is no reason why others cannot be adopted. Also, the charts in this chapter feature daily data, but this approach can be applied to any time period.
Since cloud span A, the thicker line, is derived from the shorter-term conversion and standard lines, it moves faster than span B, which relies on its construction from a longer 52-period average high/low relationship.
Time Frames
As with any other form of technical methodology, it’s often a good idea to try to gain some understanding of the direction of the longer-term and more dominant trend than that being plotted. In this chapter, we have focused on daily charts and short-term and intermediate time frames. However, it also makes sense to explore the clouds being formed on th
e more dominant weekly and monthly charts. Traders with a very near-term horizon are encouraged to experiment with intraday time periods.
Interpretation
The Major Trend Since the cloud is constructed from price action and this action is projected 26 days into the future, it indicates future support/resistance zones. An example is shown in Chart 18.10. It also shows that when the price is above the cloud, the cloud acts as a natural support area and vice versa. It’s also a characteristic that prices interact with the outer and inner edges of the cloud.
CHART 18.10 Microsoft 2012 Ichimoku Cloud Resistance Points
The trend is up when the price is above the cloud and down when it is under it. It is considered neutral when the price is actually in the cloud. However, some analysts believe that the direction from which the price entered the cloud determines the direction of the trend. That would mean that if, for example, in a bull market the price drops into the cloud, the prevailing positive trend is still considered to be in force. Only when the price falls completely through the cloud is the trend deemed bearish. A compromise approach would say that when the price enters the cloud from above, this reduces the strength of the uptrend. At that time, the consensus of other indicators is then used to come to a meaningful conclusion as to the true state of the trend.
The quality of the uptrend is strengthened when the leading span A (thick cloud border) is rising and is above the leading span B (thin cloud border). This situation produces a light cloud (normally green when colors are available) on the chart. Conversely, a downtrend, when the price is below the cloud, is reinforced when the leading span A (normally green cloud line) is below the leading span B (normally red cloud line). Chart 18.11 just features the cloud.
CHART 18.11 Amazon, Ichimoku Cloud Bullish and Bearish Signals
The bullish and bearish periods are indicated with the arrows, and at point A the cloud span crosses above B for a stronger trend signal. At B1 and B2, the price slips into the cloud itself and the trend is then defined as being flat. At just after B1, it moves back above the cloud again and is bullish.
Chart 18.12 also flags bullish and bearish signals. Coming into the chart, the trend is bullish even though the price is declining. At A, it falls into the cloud, generating a neutral signal. As it rises through the (thick) span A, a bullish trend is again signaled. Unfortunately, the bottom building process results in another whipsaw at C. This is quickly resolved with a bullish signal at D. The trend remains positive all the way through until G. However, the A span cloud border (thick) line crosses below the B (thin) line at E. This tells us that upside momentum is dissipating and takes the positive trend down a notch. Note at E how the cloud changes temporarily from a light (normally green) to a dark (normally red) highlight. We quickly see a regaining of momentum at F as the lines revert to their former status. After a false break to the downside at G and a subsequent small rally, a downtrend is signaled at H as the price slips below the lower boundary of the cloud.
CHART 18.12 S&P Composite ETF
Chart 18.10 shows how the cloud served as a resistance level for the Microsoft price in 2012. When the cloud is extended, as it is in this chart, it is helpful in that it indicates future potential levels of support or resistance.
Shorter-Term Signals
The relationship between the price and the conversion and base lines can be used to identify faster, and more frequent, signals. In conjunction with the idea that pro-trend signals are generally stronger than contratrend signals, positive conversion/base line crossovers are reinforced when prices are above the cloud and the cloud has a light (green) shading. Bearish signals are reinforced when prices are below the cloud and the cloud has a (red) dark highlight. Conversely, signals that are counter to the existing trend are deemed weaker.
Chart 18.13 features the iShares Germany ETF, the EWG, with the clouds and lines, but excluding the lagging line to reduce the clutter. The period marked by the arrows on the left indicates when the price is below the cloud and, therefore, identifies when the trend is bearish. The thick conversion line crosses below the dashed base line at point A, and the short-term system stays bearish until it crosses back above it at B. The period between B and C experienced ranging action, a trading characteristic not suitable for cloud analysis. Then at C we see another buy signal, but when it was generated, the price was slightly below the cloud, thereby flagging a bear trend. It would have been possible to enter the trade when the price crossed above the cloud because it had not moved much by this point and would not have been overbought. In this instance, a good profit would have been earned by the time the sell signal was triggered at D.
CHART 18.13 iShares Germany ETF, 2011–2012 Ichimoku Cloud Short-Term Buy and Sell Signals
Summary
1. Price often moves in proportions, the most common of which are one-half, one-third, and two-thirds.
2. Speed resistance lines, Fibonacci fans, and Gann fans offer potential support/resistance pivotal points.
3. Ichimoku cloud charts offer both longer-term and short-term trend signals.
4. Future cloud action indicates potential support/resistance areas.
5. Cloud charts can be plotted for any time frame, from intraday to monthly.
19 THE CONCEPT OF RELATIVE STRENGTH
The Concept
Relative strength (RS) is a technical concept that measures the relationship between two securities. It’s important to note that relative strength as we will be using it here has nothing to do with Welles Wilder’s relative strength indicator (RSI), which is discussed in Chapter 14.
The concept explained here is comparative relative strength, where the price of one security is divided by that of another. The result is then plotted as a continuous line whose trend is then analyzed. There are several ways in which relative strength can be used:
1. To compare one asset class to another in order to decide which one to buy, or to better understand an intermarket relationship. For example, we might compare gold to bonds to see which was in a rising trend. If the relationship was in an uptrend, it would indicate that on a price basis, gold was outperforming bonds and that it was, therefore, the preferred asset. It would also tell us that the market was anticipating an inflationary environment since gold is largely purchased as an inflation hedge, whereas credit-worthy bonds typically do better in deflationary times.
Another possibility might arise when a review of the technical position indicates that both the U.S. and Japanese stock markets are in a bullish trend. Analyzing the trend of the relationship between them indicates which market is likely to outperform.
2. In commodity trading, a spread is a form of relative strength. A spread involves the relationship between one commodity and another, such as corn to hogs. Alternatively, a spread captures the relationship between a distant contract and a nearby one. In this instance, traders are attempting to discover relationships that have diverged from the norm and riding on the spread until the two contracts come back into line. Moreover, changes in these relationships also warn of emerging surplus or shortage conditions that help in supply/demand analysis relative to current and future conditions.
3. A currency is really a relative relationship. For example, there is no such thing as the U.S. dollar in an external sense, because it consists of a number of cross-rates: dollar-yen, euro-dollar, Canadian-U.S.dollar, and so forth. Each currency is merely a relationship between itself and other currencies.
4. Sometimes the relative action between two entities reflects confidence and can be used for the purpose of analyzing the market itself. For example, we may find that the ratio between the technology and consumer staple sectors is falling. Technology reflects hot money that flows when confidence is high, and consumer staples are defensive issues that investors buy when they are apprehensive. A declining trend in this relationship would therefore reflect declining confidence and represent a bearish factor. This is a different type of relative relationship, which is covered in greater detail in Cha
pter 28.
5. The most common and important use of relative strength is to compare the price of a security to an index corresponding to its universe. The most common example would be a stock to a market average. For example, we might compare the performance of Facebook to the S&P Composite. If the resultant RS line is rising, it would mean that Face-book was outperforming the market and vice versa.
It is this concept of comparing an individual security to a market average that we will be concentrating on in this chapter. Please note that unless otherwise stated, all relative strength comparisons are calculated against the S&P Composite.
Major Technical Principle Relative strength is a very powerful-concept that facilitates individual stock selection.
Construction of an RS Line
An RS line is obtained by dividing the price of one item by another. The numerator is usually a stock, and the denominator a measurement of “the market,” for example, the NASDAQ or the S&P 500. Outside the US it would be a stock price compared to a specific country average such as the DAX in Germany, the Nifty in India and so forth. In later chapters we will also look at the relative relationships between sectors and industry groups against the market, as this represents a shortcut method of stock selection. For example, it is quicker to study the RS lines for 12 sectors and then study the components of the selected area than to review 3,000 to 5,000 individual stocks.