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  Length of the Line

  The size or length of a trend is an important factor, as with price patterns. If a series of ascending bottoms occurs over a 3- to 4-week span, the resulting trendline is only of minor importance. If the trend extends over a period of 1 to 3 years, however, its violation marks a significant juncture point. Just remember: Big trends result in big signals, small trends in small signals.

  Number of Times the Trendline Has Been Touched or Approached

  A trendline also derives its authority from the number of times it has been touched or approached; i.e., the larger the number, the greater the significance. This is true because a trendline represents a dynamic area of support or resistance. Each successive “test” of the line contributes to the importance of this support or resistance, and thus the authority of the line is a true reflection of the underlying trend. Just remember that a close encounter to the line (an approach) is almost as important as an actual touching because it still reflects the line’s importance as a support or resistance area.

  Also, if a line gains significance from the fact that it has been touched or approached, the extended line will become equally as important, but from a reverse point of view, since extended lines reverse their support/resistance functions.

  Angle of Ascent or Descent

  A very sharp trend, as in Figure 6.15, is difficult to maintain and is liable to be broken rather easily, even by a short sideways movement.

  FIGURE 6.15 Steep Angles of Ascent

  All trends are eventually violated, but the steeper ones are likely to be ruptured more quickly. The violation of a particularly steep trend is not as significant as that of a more gradual one. Penetration of a steep line usually results in a short corrective movement, following which, the trend resumes, but at a greatly reduced and more sustainable pace. Usually, the penetration of a steep trendline represents a continuation rather than a reversal break.

  Major Technical Principle The significance of a trendline is a function of its length, the number of times it has been touched, and the angle of ascent or descent.

  Measuring Implication

  Trendlines have measuring implications when they are broken, just as price patterns do. The maximum vertical distance between the peak in the price and the trendline is measured during a rising trend (see Figure 6.16).

  FIGURE 6.16 Measuring Implications of Down Trendlines

  This distance is then projected down from the point at which the violation occurs. The opposite for an up trendline violation is shown in Figure 6.17.

  FIGURE 6.17 Measuring Implications of Up Trendlines

  The term price objective is perhaps misleading. Objectives are usually reached when a trendline violation turns out to be a reversal, but because they are more often exceeded (as with price patterns), the objective becomes more of a minimum expectation. When prices move significantly through the objective, this area often becomes one of resistance to the next major rally, or support, for a subsequent reaction. Figures 6.18 and 6.19 show the some of these possibilities in both a down and up market.

  FIGURE 6.18 Downside Measuring Objectives

  FIGURE 6.19 Upside Measuring Objectives

  Time and again, these price objective areas prove 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 a point made earlier: that there is no known way of consistently determining the duration of a price movement. It is only possible to speculate on the probability that a specific area will prove to be an important turning point.

  Corrective Fan Principle

  At the beginning of a new primary bull market, the initial intermediate rally is often explosive, and so the rate of ascent is unsustainably steep. This happens because the advance is often a technical reaction to the previous overextended decline, as speculators who were caught short rush to cover their positions. As a result, the steep trendline constructed from the first minor reaction is quickly violated.

  This is represented as line AA in Figure 6.20. A new trendline is then constructed, using the bottom of this first intermediate decline (AB).

  FIGURE 6.20 The Fan Principle

  The new line rises at a less rapid rate than the initial one. Finally, the process is repeated, resulting in construction of a third line, AC. These lines are known as fan lines. There is an established principle that once the third trendline has been violated, the end of the bull market is confirmed. In some respects, these three rally points and trendlines can be compared to the three stages of a bull or bear market, as outlined in Chapter 3. The fan principle is just as valid for downtrends, and can also be used for determining intermediate as well as cyclical movements.

  Trend Channels

  So far, only the possibilities of drawing trendlines joining bottoms in rising markets and tops in declining ones have been examined. It is also useful to draw lines that are parallel to those basic trendlines, as shown in Figure 6.21.

  FIGURE 6.21 Uptrend Channel

  In a rising market, the parallel line known as a return trendline joins the tops of rallies, and during declines, the return line joins the series of bottoms (see Figure 6.22). The area between these trend extremities is known as a trend channel.

  FIGURE 6.22 Downtrend Channel

  The return line is useful from two points of view. First, it represents an area of support or resistance, depending on the direction of the trend. Second, and perhaps more important, penetration of the return trendline represents a signal that either the trend will accelerate or a reversal in the basic trend is about to take place, at least temporarily.

  In Figure 6.23, the violation of the return line signifies that the price advance has begun to accelerate. In effect, the channel in Figure 6.23 represents a rising trading range, and the trendline violation is a breakout from it.

  FIGURE 6.23 Breakout from Uptrend Channel

  Exhaustion

  On the other hand, if the angle of the trend channel is much steeper, as in Figures 6.24 and 6.25, the violation of the return line represents an exhaustion move.

  FIGURE 6.24 Exhaustion Break from Downtrend Channel

  FIGURE 6.25 Exhaustion Break from Uptrend Channel

  The failure of the price to hold above (or below) the return line then signals an important reversal in trend. This is often the case if the break through the return line is accompanied by high volume.

  Consider a situation in which a person is sawing a thick piece of wood. At first, the sawing strokes are slow but deliberate, but gradually, the person realizes that this task is going to take some time, becomes frustrated, and slowly increases the speed of the strokes. Finally, the person bursts into a frantic effort and is forced to give up the task, at least temporarily, because of complete exhaustion. The same principles hold true in a declining market. In this case, the expanding volume at the low represents a selling climax. As a general rule, the steeper the channel, the more likely it is that the breakout will turn out to be an exhaustion move.

  Exhaustion also develops when a price rallies temporarily above a regular down trendline (or below an up trendline) and then breaks back below (or above) it. In the case of a down trendline, the situation is akin to someone jumping up and temporarily pushing through the ceiling. The person is able to pull their head through to the next floor for a few moments, but then falls sharply back to the floor below. At this point, he has used up all spare energy in the attempt to move to the next floor and is totally exhausted. Before he can make another attempt, he will need some time to gain some new energy. The same is true of the price, which makes an effort to rally above the trendline but is unable to maintain the breakout.

  This temporary break often indicates that the prevailing trend has much further to run. It also raises a dilemma concerning the way in which a trendline should be constructed. In Figure 6.26, for instance, we see a false break above trendline AB.

  FIGURE 6.26 Down Trendline Exhaustion Brea
k

  Should AB now be abandoned, or should the peak of the exhaustion break be connected to the rally high to form a new (dashed AC) trend-line? Again, it’s a matter of common sense. On the one hand, the top of the whipsaw break is technically the correct place to draw the line, but common sense suggests that the original line is a better reflection of the underlying trend. After all, at the time of the whipsaw, it had been touched three times. If a new line is then drawn to reflect the break, that line will have been touched only twice, once at the outset and once at the whipsaw peak. In a sense, the whipsaw is adding further credibility to the initial line because the price was unable to hold above it. If we had come upon this situation after the whipsaw break and tried to construct a line, it would have been even more obvious that line AB was far superior to line AC because it has been touched or approached on far more occasions.

  Chart 6.9 shows that a resistance trendline joining the 1974 low and 1978 highs was temporarily violated. This proved to be an exhaustion move, since the S&P Composite was unable to hold above the line. This failure was followed by the 1987 crash. Not all exhaustion moves result in such dynamic consequences, but they certainly warn of potential trouble and should never be ignored.

  CHART 6.9 S&P Composite 1973–1989

  The same principles are true in reverse for an up trendline. When you think about it, a whipsaw break actually adds credibility to the trendline. This is because the price is able to violate the line, but this line is so significant as a support/resistance area that the price is unable to hold the break. If it were not such a significant barrier, the break would have held and the whipsaw would have been avoided. Consequently, when the price is able to experience a valid break, the signal is that much stronger.

  Chart 6.10 shows an example of a whipsaw downside break for Microsoft in 1998.

  CHART 6.10 Microsoft

  Major Technical Principle Exhaustion develops when a price rallies temporarily above a down trendline (or below an up trendline) and then breaks back below (or above) it.

  Summary

  1. Trendlines are perhaps the easiest technical tool to understand, but considerable experimentation and practice are required before the art of interpreting them can be successfully mastered.

  2. Trendline violations signal either a temporary interruption or a reversal in the prevailing trend. It is necessary to refer to other pieces of technical evidence to determine which is being signaled.

  3. The significance of trendlines is a function of their length, the number of times they have been touched or approached, and the steepness of the angle of ascent or descent.

  4. A good trendline reflects the underlying trend and represents an important support and resistance zone.

  5. Extended trendlines are an important concept and should not be overlooked.

  6. Exhaustion breaks often possess good predictive power.

  7 BASIC CHARACTERISTICS OF VOLUME

  Almost everything that technicians use in plotting a specific security involves either the price itself or a statistical variation on it. Volume can offer a new dynamic in our interpretation of crowd psychology. Therefore, analyzing volume trends gives us a better understanding of how and why price patterns work. In effect, the study of the characteristics of volume gives greater depth to the weight-of-the-evidence approach described earlier. Volume not only measures the enthusiasm of buyers and sellers, but also is a variable that is totally independent of price. In this chapter, we will discuss some general principles of volume interpretation, and in Chapter 26 some individual volume indicators. We are beginning our volume coverage at this point, as it is a basic building block of price patterns, in a similar way to the concepts of support and resistance, peak-and-trough analysis, and trendlines. At the end of this chapter all the basic building blocks will have been covered, leaving us prepared to tackle the subject of price patterns head on.

  Benefits of Volume Studies

  Volume studies offer three major benefits:

  1. When price and volume patterns are compared, it is important to see whether they are in agreement. If so, the probabilities favor an extension of the trend.

  2. If price and volume disagree, this tells us that the underlying trend is not as strong as it looks on the surface.

  3. Occasionally, price action offers mild signs of an impending trend reversal, but volume can throw up characteristics of its own that literally shout this message. In such cases, a study that was limited to price action would fail to uncover a really good and obvious warning or opportunity.

  Principles of Volume Interpretation

  1. The first and most important principle is that volume typically goes with the trend. It is normal for activity to expand in a rising market and to contract in a declining one (see Figure 7.1). In this sense, volume is always interpreted in relation to the recent past.

  FIGURE 7.1 Volume Goes with the Trend

  Comparing twenty-first-century 1 billion-plus share days on the New York Stock Exchange (NYSE) with early twentieth-century levels of 5 or 6 million is of little help. Such a comparison reflects institutional, not psychological, changes. Volume is higher today because of more companies being listed, the advent of derivatives, lower commissions, and so forth. On the other hand, a 3-billion-share day this week compared to a recent 1.5-billion-share day last month is relevant, because it shows a significant change in activity over a period in which major institutional changes will be nonexistent.

  We know that when prices move in trends, this does not occur in a straight line. Instead, the price works its way up and down in a zigzag fashion. Volume trends are similar. On the left side of Figure 7.2, for instance, the solid arrows indicate an expanding volume trend and the dashed ones declining trends.

  FIGURE 7.2 Volume Moves in Trends

  It is apparent that the level of activity does not expand in every period. There are quiet periods and active ones, but the general thrust is up. It, too, is irregular. When we talk about volume rising or falling, we are usually referring to its trend. It is normal for such trends to be interrupted by aberrations in volume levels. Volume trends, like price trends, can be intraday, short, intermediate, or long, depending on the nature of the chart.

  The amount of money flowing into a security must always equal the amount of money flowing out. This is true regardless of the level of volume. Consequently, it is the degree of enthusiasm of buyers or sellers that determines the course of prices. If buyers are bullish, they will raise their bids until their demands are satisfied. If sellers react to bad news, they may panic, pushing prices down sharply, but at all times, the amount of a security being sold is equal to that being purchased.

  2. The combination of rising volume and rising price is normal. It indicates that things are in gear. Such a state of affairs has no forecasting value, except to imply that it is likely that a negative divergence between price and volume lies ahead.

  3. Volume normally leads price during a bull move. A new high in price that is not confirmed by volume should be regarded as a red flag, warning that the prevailing trend may be about to reverse. In Figure 7.3 the price peaks at point C, yet the average volume reached its maximum around point A.

  FIGURE 7.3 Volume Leads Price in an Uptrend

  Such action is normal; the declining volume peaks warn of underlying technical weakness. Unfortunately, there are no hard-and-fast rules about how many divergences precede a peak. Generally speaking, though, the greater the number of negative divergences, the weaker the underlying technical picture. Also, the lower the peaks relative to each other, the less enthusiasm is being generated, and the more vulnerable the technical position becomes, once buying dries up or selling enthusiasm intensifies. A new high that is accompanied by virtually no volume is just as bearish as a new price high with virtually no upside momentum.

  An example is shown in Chart 7.1 for Aligent Technology, where you can see that the volume clusters gradually become smaller as the price rallies. Eventually, this negative technic
al characteristic is confirmed as the price violates the 2010–2011 up trendline in early July 2011.

  CHART 7.1 Aligent Technology 2010–2011

  4. Rising prices accompanied by a trend of falling volume (Figure 7.4) is an abnormal situation. It indicates a weak and suspect rally and is a bear market characteristic.

  FIGURE 7.4 Rising Prices and Falling Volume Is Bearish

  When it is recognized, it can and should be used as a piece of evidence pointing to a primary bear market environment. Volume measures the relative enthusiasm of buyers and sellers. When it shrinks as prices rise, the advance occurs because of a lack of selling rather than because of sponsorship from buyers. Sooner or later, the trend will reach a point where sellers become more motivated. After that, prices will start to pick up on the downside. One clue is provided when activity increases noticeably as the price starts to decline. This is shown in Figure 7.5, where you can see that volume starts to pick up as the price starts a sell-off.

  FIGURE 7.5 Falling Prices and Rising Volume Is Bearish

  In such situations, it is not necessary for volume to expand throughout the decline, as it does in this example. It could be that it picks up for two or three bars just after the peak. In fact, this would be a more typical situation.