Technical Analysis Explained Read online

  Chart 5.10 features the gold price. Note how it makes a high in January 1986 and then falls away. The subsequent rally is quite steep; then the price runs out of steam and declines again.

  CHART 5.10 Gold

  Finally, in late July, it works its way higher in a fairly methodical manner. This time, the same level of resistance is easily overcome because buyers are not as exhausted as they were in their March attempt.

  Examine the Amount of Time Elapsed

  The third rule for establishing the potency of a support or resistance zone is to examine the amount of time that has elapsed between the formation of the original congestion and the nature of general market developments during that period. A supply that is 6 months old has greater potency than one established 10 or 20 years previously. Even so, it is almost uncanny how support and resistance levels remain effective time and time again, even when separated by many years.

  Summary

  1. Support and resistance represent a concentration of demand and supply sufficient to halt a price move, at least temporarily.

  2. They are not signals to buy or sell, but intelligent places for anticipating a reversal and should always be used in conjunction with other indicators.

  3. Potential support/resistance zones develop at previous highs and lows, round numbers, trendlines and MAs, emotional points on charts, and retracement points such as Fibonacci proportions.

  4. The significance of a support or resistance zone depends upon the amount of an asset that previously changed hands in that area, the speed and extent of the previous price move, and the period of time that has elapsed since the zone was last encountered.

  6 TRENDLINES

  Trendlines are perhaps the simplest of the tools we use in the technical arsenal and are arguably one of the most effective. Since the construction of nearly all price patterns requires the use of trendlines, this concept is a fundamental building block of pattern identification and interpretation—the subject of Chapter 8. In this chapter, we will describe trendline characteristics and explain how the significance of individual lines can be determined.

  A trendline is a straight line connecting either a series of ascending bottoms in a rising market or the tops of a descending series of rally peaks. Those joining the lows are called up trendlines, and those connecting the tops are referred to as down trendlines. It is also possible to construct horizontal trendlines joining a series of identical lows or identical highs. Typically, a down trendline is constructed by joining the final peak with the top of the first rally, as in Figure 6.1.

  FIGURE 6.1 Down Trendline Connecting the Peaks

  When the price breaks above the trendline, a trend change signal is given. The opposite is true for an up trendline (see Figure 6.2).

  FIGURE 6.2 Up Trendline Connecting the Troughs

  How to Draw Trendlines

  In order for a line to be a true trendline, it must connect two or more peaks or troughs. Otherwise, it will be drawn in space and will have no significance. You will often see people constructing lines that only touch one point, as in Figure 6.3, or even no points at all, as in Figure 6.4.

  FIGURE 6.3 Incorrect Down Trendline Construction

  FIGURE 6.4 Incorrect Down Trendline Construction

  Such lines have no meaning whatsoever, and are really worse than drawing nothing at all. This is because by simply appearing on the charts, such lines give the observer the impression that they actually have some significance. It’s a fundamentally important point because

  Major Technical Principle A true trendline is a graphic way of representing the underlying trend.

  Consequently, if it only touches one point, it cannot be true trendline.

  Ideally, an up trendline is constructed by connecting the final low with the first bottom in the rally, as line AD in Figure 6.5.

  FIGURE 6.5 Primary and Secondary Up Trendlines

  This is called the primary trendline. In the case of a primary trend, this would be the bear market low and the first intermediate bottom. The example shown here offers a fairly shallow angle of ascent. Unfortunately, the price rallies sharply, which means that the violation develops well after the final peak. In such situations, it is better to redraw the line as the price moves up. In Figure 6.5, this is line BC, which is obviously a better reflection of the underlying trend. This is called a secondary trendline. Down trendlines are constructed using the same principles, but in reverse.

  Since trends can be sideways, it follows that trendlines can also be drawn horizontally, which is often the case when we construct price patterns such as the neckline of a horizontal head-and-shoulders (H&S) pattern or the upper or lower boundaries rectangles (described in later chapters). In the case of price patterns, the penetration of these lines usually warns of a change in trend, as does the violation of rising or falling trendlines.

  It’s important to understand the following principle at this point.

  Major Technical Principle Drawing trendlines is more a matter of common sense rather than following a set of hard-and-fast rules.

  Bar Versus Line or Close-Only Charts

  Some charts are plotted with bars and others as line charts. The question naturally arises as to which form should be used for the purposes of trend-line analysis. In most cases, bar charts offer more timely signals, whether it’s a peak-and-trough progression, price pattern completion, or trendline violation. In technical analysis, timeliness comes with a price, and the price in this case is more whipsaws. With traditional daily or weekly charts, the closing price is very important because it sorts out the men, i.e., those who are willing to take home a position overnight or over a weekend, from the boys, i.e., those who are not. This has become less important as a factor for markets that trade for 24 hours, Sunday through Friday. However, since all markets are closed over the weekend, Friday closes continue to maintain their importance. Even so, closing prices are, for the most part, more important chart points than highs or lows. Also, since there is much excitement during the day as unexpected news breaks, highs and lows often represent random points on the chart. For this reason, it is often a better idea to construct trendlines using closing data. I am not going to say that’s always the case, because some bar trendlines have greater significance than close-only ones, based on the rules outlined for significance described later in this chapter. Thus, it is always crucial to apply common sense as much as strict technical rules. The question you should be constantly asking is, “Which line better reflects the underlying trend?”

  Trendline Breaks Can Be Followed by a Reversal or Consolidation

  The completion of a price pattern can signify either: (1) a reversal in the previous trend—in this instance, it is known as a reversal pattern—or (2) a resumption of the previous trend, when it is called a consolidation or continuation pattern. Similarly, the penetration of a trendline will result in either a reversal of that trend or its continuation. Figure 6.6 illustrates this point from the aspect of a rising price trend.

  FIGURE 6.6 Implication of a Trendline Break-Reversal

  In this case, the trendline joining the series of troughs is eventually penetrated on the downside. The fourth peak represented the highest point in the bull trend, so the downward violation of the trendline signals that a bear move is under way.

  The upward price trend and trendline penetration in Figure 6.7 are identical to those in Figure 6.6, but the action following this warning signal is entirely different.

  FIGURE 6.7 Implication of a Trendline Break-Slowed Momentum

  This is because the trendline violation results in the advance continuing, but at a slower rate. A third alternative is that the price consolidates in a sideways trading range and then advances (Figure 6.8).

  FIGURE 6.8 Implication of a Trendline Break-Continuation After Consolidation

  Finally, it may consolidate and then reverse to the downside. This is shown in Figure 6.9.

  FIGURE 6.9 Implication of a Trendline Break-Reversal After Consolidation

>   Thus, whenever a trendline is violated, the odds strongly favor a change in trend. That change can either be an actual reversal or a (sideways) trading range following an uptrend or downtrend.

  In most instances, there is, unfortunately, no way of telling at the time of the violation which possibility will prove to be the outcome. Generally speaking though, the violation of trendlines with a sharp angle of ascent or descent is more likely to result in a consolidation. Also, valuable clues can be gleaned by applying other techniques described in subsequent chapters, and by evaluating the state of health of the market’s overall technical structure (examined in Part II). Using the techniques discussed in Chapter 8 can also help. For example, in a rising market, a trendline penetration may occur at the time of, or just before, the successful completion of a reversal pattern. An example is shown in Figure 6.10.

  FIGURE 6.10 Simultaneous Trendline and Price Pattern Breaks at Tops

  Figure 6.11 illustrates the same phenomenon from the aspect of a bear market reversal. If the violation occurs simultaneously with, or just after, the completion of a reversal pattern, the two breaks have the effect of reinforcing each other.

  FIGURE 6.11 Simultaneous Trendline and Price Pattern Breaks at Bottoms

  Sometimes, as in Figure 6.12, the trendline violation occurs before the completion of the pattern.

  FIGURE 6.12 Delayed Price Pattern Breaks at Tops and Bottoms

  In such cases, the break should be regarded as a sign of an interruption of the prevailing movement rather than one of reversal, because a trend is assumed to continue until the weight of the evidence indicates otherwise. A couple of examples of this phenomenon appear in Chart 6.1 featuring Invesco Energy Fund.

  CHART 6.1 Invesco Energy Fund 1987–1993

  This chart indicates two examples of where a trendline break and pattern completion develop close together. At the end of 1990, the Invesco Energy Fund violates a nice up trendline and shortly after, completes a right-angled broadening top. The end of the decline is signaled with another down trendline break and the completion of a reverse head-and-shoulders pattern For a full description of these patterns please refer to Chapter 8.

  Further clues to the significance of a specific trendline violation can be gleaned from volume characteristics, as described in the next chapter. For example, if a series of ascending peaks and troughs is accompanied by progressively lower volume, it is a sign that the advance is running out of steam (since volume is no longer going with the trend). In this instance, a trendline violation is likely to be of greater significance than if volume had continued to expand with each successive rally. It is not necessary for a downside penetration to be accompanied by high volume, but a violation that occurs as activity expands emphasizes the bearish undertone because of the obvious switch in the demand/supply balance in favor of sellers.

  Major Technical Principle As a general rule, the violation of trendlines with a sharp angle of ascent or descent is more likely to result in a consolidation than a reversal.

  Extended Trendlines

  Most people observe the violation of a trendline, then assume that the trend has changed and forget about the line. This is a mistake because an extended line can become just as important as the previolated line itself. The difference is that an extended line reverses its role. Just as a return move often happens following a breakout from a price pattern, a similar move, known as a throwback, sometimes develops following a trendline penetration. Figure 6.13 shows a trendline reversing its previous role as support while the throwback move turns it into an area of resistance. Figure 6.14 shows the same situation for a declining market.

  FIGURE 6.13 Extended Up Trendline

  FIGURE 6.14 Extended Down Trendline

  Chart 6.2 shows an up trendline break for the China ETF (FXI). The penetration of this line resulted in the extended line becoming resistance.

  CHART 6.2 China Fund 2011–2012

  Later it was penetrated again, and a subsequent decline showed it to be a level of support. Finally, two trendlines converged in early March, and since they had just been violated on the downside, they reinforced each other as a resistance zone that quickly resulted in the price moving to the downside.

  Major Technical Principle An extended trendline reverses its support/resistance role.

  Logarithmic (Ratio) vs. Arithmetic Scales

  Scaling is an issue that is often overlooked in the technical community, but since it can have an important influence on how trendlines can be interpreted, this is as good a place as any to introduce this concept. There are two axes on any market chart. The x axis, along the bottom, registers the date (except in point and figure charting), and the y axis, the price. There are two methods of plotting the y axis: arithmetic and logarithmic. Which one is chosen can have very important implications.

  Arithmetic charts allocate a specific point or dollar amount to a given vertical distance. Thus, in Chart 6.3, each arrow has the same vertical distance and reflects approximately 250 points. That will be true at any price level.

  CHART 6.3 S&P Composite 1870–2012 Arithmetic Scale

  A logarithmic scale, on the other hand, allocates a given percentage price move to a specific vertical distance. In Chart 6.4, each arrow represents a move of approximately 100 percent, whether it is at lower prices or higher prices. There is very little noticeable difference between the scaling methods when charts are plotted over short periods of time, where price fluctuations are relatively subdued. However, with large price fluctuations, there are considerable differences.

  CHART 6.4 S&P Composite 1870–2012 Logarithmic Scale

  The arithmetic scale suppresses price fluctuations at low levels and exaggerates them at high points. Thus, the 85 percent 1929–1932 decline hardly shows up at all in Chart 6.3, but the 40 percent late-1990s–early 2000s retreat (no small decline) is greatly exaggerated. Chart 6.4 shows that the logarithmic scaling brings back 1929 and does not exaggerate the turn-of-the-century bear market. The media love to hype stories and news because that is what sells. You will find that charts featuring financial markets or economic numbers are almost always plotted on an arithmetic scale because this has the effect of exaggerating the most recent changes. Another hyping technique used by the media is to present the data for a short period using a very limited scale. The reader is then left with the sense of a dramatic move. This would not be the case if the data were displayed over a much longer period using a wider price scale.

  As you can appreciate, I am very much in favor of using a logarithmic scale because it displays price trends in a proportionate way. Psychology tends to move proportionately as well, so it makes perfect rational sense to use logarithmic scaling. Having said that, when price fluctuations are relatively small—say, over a 3-month period—there is very little difference between the two scaling methods. As a purist, though, I still prefer the log scale at all times.

  There is an even more important advantage of the logarithmic scale, which we shall learn when the concept of pattern price objectives is discussed later, but for now let’s consider the implications for trendline interpretation.

  The choice of scale is important for a timely and accurate use of trendline analysis, because at the end of a major movement, prices tend to accelerate in the direction of the prevailing trend; i.e., they rise faster at the end of a rising trend and decline more sharply at the termination of a bear market. In a bull market, prices rise slowly after an initial burst and then advance at a steeper and steeper angle as they approach the ultimate peak, looking rather like the left-hand cross-section of a mountain. Chart 6.5 shows an up trendline break for Intel based on a logarithmic scale.

  CHART 6.5 Intel 2001–2002 Logarithmic Scale

  Note that the downside penetration develops in mid-December. Chart 6.6 shows exactly the same period, but this time, the scaling is arithmetic.

  CHART 6.6 Intel 2001–2002 Arithmetic Scale

  The trendline break is entirely different, since it initially comes as
a whipsaw in late December, followed by a valid break in mid-January. The downward-pointing arrow on the left marked the logarithmic break. Thus, it is apparent that up trendlines are violated more quickly on a logarithmic than on an arithmetic scale.

  Conversely, down trendlines are violated sooner on an arithmetic scale. This can be seen from a comparison of Charts 6.7 and 6.8 for IBM.

  CHART 6.7 IBM 2001–2002 Arithmetic Scale

  CHART 6.8 IBM 2001–2002 Logarithmic Scale

  Generally speaking, penetration of a logarithmically drawn trend-line is more accurate in reflecting trend reversals than is penetration of an arithmetically drawn trendline; however, if the arithmetically constructed one is substantially more significant, based on the criteria listed next, then that would be the one to go with.

  Significance of Trendlines

  It has been established that a break in trend caused by the penetration of a trendline results in either an actual trend reversal or a slowing in the pace of the trend. Although it may not always be possible to assess which of these alternatives will develop, it is still important to understand the significance of a trendline penetration; the following guidelines should help in evaluation.