Technical Analysis Explained Read online

  Figure 7.6 shows how the volume configurations change between a bull market and a bear market.

  FIGURE 7.6 Volume Characteristics Change in Bull and Bear Markets

  Chart 7.2 shows the final rally being accompanied by a trend of declining volume for Coors. When the lower trendline is violated, volume picks up noticeably. In this instance, we have one bearish volume configuration that is instantly followed by another.

  CHART 7.2 Coors 2000–2001

  Chart 7.3 shows several bear market rallies in which the rising price trend is accompanied by declining volume for Radio Shack.

  CHART 7.3 Radio Shack 2000–2001

  5. Sometimes both price and volume expand slowly, gradually working into an exponential rise with a final blow-off stage. Following this development, both volume and price fall off equally sharply. This represents an exhaustion move and is characteristic of a trend reversal, especially when supported by a one- or two-bar price pattern (discussed in subsequent chapters). The significance of the reversal will depend upon the extent of the previous advance and the degree of volume expansion. Obviously, an exhaustion move that takes 4 to 5 days to develop will be nowhere near as significant as one that develops over a matter of weeks. This phenomenon is termed a parabolic blow-off and is featured in Figure 7.7.

  FIGURE 7.7 Parabolic Blow-Off

  Unfortunately, exhaustion, or blow-off, moves such as this are not easy to define in the sense that it is possible to construct clearly definable trendlines or price patterns. For this reason, it is usually not possible to spot the terminal phase until a period or so after volume and price have reached their crescendos. Furthermore, because of their nature, parabolic blow-offs are quite rare.

  Chart 7.4 uses Newmont Mining to demonstrate a classic example of an exponential increase in both price and volume that ends in tears in the form of an abrupt reversal in late September 1987. We see another in Chart 7.5 featuring Amrep Ordinary.

  CHART 7.4 Newmont Mining 1986–1987

  CHART 7.5 Amrep Ordinary 2003–2009

  6. A selling climax is the opposite of a parabolic blow-off. It occurs when prices fall for a considerable time at an accelerating pace, accompanied by expanding volume. Prices typically rise after a selling climax. The low that is established at the time of the climax is unlikely to be violated for a considerable time. I emphasized the word unlikely because there are no guarantees, just a strong probability. Clearly, a selling climax is likely to be more of an indication of a final short- or intermediate-term bottom in a bull market. A price rise from a selling climax is by definition accompanied by declining volume. This is the only time when contracting volume and a rising price may be regarded as normal. Even so, it is important to make sure that volume expands on subsequent rallies, as indicated in Figure 7.8.

  FIGURE 7.8 Selling Climax

  The termination of a bear trend is often, but not always, accompanied by a selling climax. Unlike parabolic blow-offs, which are quite rare, selling climaxes appear on the charts far more often and are, therefore, quite a common technical phenomenon.

  In Chart 7.6, we see a selling climax develop in 2010 for Andarco Petroleum. This is then followed by a rally and a subsequent test on lower volume. Note how volume declines on the rally, a perfectly normal characteristic following a selling climax.

  CHART 7.6 Andarco Petroleum Ordinary 2009–2012

  7. When prices advance following a long decline and then react to a level at, slightly above, or marginally below the previous trough, this is a bullish sign if the volume on the second trough is significantly lower than the volume on the first. There is an old saying on Wall Street, “Never short a dull market.” This saying applies very much to this type of situation, in which a previous low is being tested with very low volume. Such a situation indicates a complete lack of selling pressure (see Figure 7.9).

  FIGURE 7.9 Look for Low Volume when Testing Lows

  8. A downside breakout from a price pattern, trendline, or moving average (MA) that occurs on heavy volume is abnormal and is a bearish sign that confirms the reversal in trend (Figure 7.10).

  FIGURE 7.10 Rising Volume on a Downside Breakout Is Bearish

  When prices decline, it is usually because of a lack of bids, so volume contracts. This is normal activity and does not give us much information. However, when volume expands on the downside, it is because sellers are more motivated, so the decline, other things being equal, is likely to be more severe.

  9. When the price has been rising for many months, an anemic rally (Figure 7.11) accompanied by high volume indicates churning action and is a bearish factor.

  FIGURE 7.11 Churning Is Bearish

  An example featuring Dresser Industries is shown in Chart 7.7.

  CHART 7.7 Dresser Industries Petroleum 2007–2009

  10. Following a decline, heavy volume with little price change is indicative of accumulation and is normally a bullish factor (Figure 7.12).

  FIGURE 7.12 Accumulation Is Bullish

  11. Record volume coming off a major low is usually a very reliable signal that a significant bottom has been seen. This is because it indicates that an underlying change in psychology has taken place. Such reversals in sentiment are usually of a primary trend magnitude. Examples in the U.S. stock market developed in March 1978, August 1982 and 1984, and October 1998. A similar pattern also developed at the 1987 low in bonds and eurodollars. This is not an infallible indicator, though, because record volume was achieved in January 2001 for both the NYSE and NASDAQ, yet this did not turn out to be the final low for the bear market, which was achieved over a year later in October 2002.

  12. When volume and price expand at a sharp pace, but short of a parabolic blow-off, and then contract slightly, this usually indicates a change in trend. Sometimes this is an actual reversal and at other times a consolidation. This phenomenon is featured in Figure 7.13 and represents a temporary exhaustion of buying power.

  FIGURE 7.13 Extremely High Volume After a Sharp Advance Indicates Exhaustion

  It is associated with several one- and two-bar price patterns, discussed in later chapters. The example shows the price eventually selling off, but it could just as easily have risen. All the volume crescendo is telling us is that buyers are exhausted and we should expect a pause. When that buying is exceptionally heavy, a more bullish extreme in sentiment is indicated and is more likely to be followed by an extended period of price erosion, as shown in Figure 7.13.

  13. When the price experiences a small rounding top and volume experiences a rounding bottom, this is a doubly abnormal situation, since price is rising and volume is falling as the peak is reached. After the peak, volume expands as the price declines, which is also abnormal and bearish. An example is shown in Figure 7.14. An example featuring Microsoft is featured in Chart 7.8. Note how the letter n characterizes the price action, whereas the volume configuration is closer to letter u.

  FIGURE 7.14 Watch Volume on Rallies and Reactions

  CHART 7.8 Microsoft 2007–2009

  14. When the price volatility shrinks to almost nothing and volume does the same, this indicates total disinterest. When the situation is eventually resolved, this is often followed by an above-average price move. In Figure 7.15, for instance, price and volume fall to the kind of levels where the slightest movement in either direction will signal a dramatic price movement.

  FIGURE 7.15 Exceptionally Low Volume Is Very Bullish when Confirmed by Price and Expanding Volume

  In this case, the down trendline is violated on the upside and volume explodes; so, too, do prices. Generally speaking, the quieter the price and volume action relative to the preceding downtrend, the more explosive the confirmed subsequent rally is likely to be. In this case, “confirmed” means some kind of a price trend reversal accompanied by expanding volume.

  A very narrow balance between buyers and sellers is certainly apparent in Chart 7.9, which features ICIC Bank.

  CHART 7.9 ICIC Bank 2008

  Note the shrinking vo
latility of the price activity and the accompanying trend of lower and lower volume. The balance between buyers and sellers is extremely fine as we roll into early September. Then the price breaks to the downside and volume expands. That’s the signal for an above-average price decline

  None of the indicators used in the technical arsenal are guaranteed to work every time. This is certainly true of volume characteristics. However, when volume is used in combination with price characteristics in pattern interpretation, trendline violations and moving average crossovers it greatly enhances the probability that a specific setup or formation will “work.” As we discuss specific price examples in subsequent chapters, the basic volume principles described here will be expanded to suit individual cases.

  You will also be able to appreciate at this point that most of the time volume as an indicator is not telling us very much. However, when it does speak and is confirmed by other indicators, a loud message is indeed given.

  Summary

  1. Volume is a totally independent variable from price.

  2. It is normal for volume to go with the trend. When these characteristics are present, they have little forecasting value.

  3. When volume trends are moving in a direction opposite to that of price, this is abnormal and either warns of an impending trend reversal or emphasizes the significance of any breakout.

  4. Volume trends experience exhaustion phenomena. These are called parabolic blow-offs at tops and selling climaxes at lows.

  8 CLASSIC PRICE PATTERNS

  In earlier chapters we discussed the concepts of peak-and-trough progression, support and resistance, trendlines, and rudimentary volume characteristics. These are all basic building blocks of price pattern construction. Now it’s time to put them all together to gain a better understanding of how we recognize, interpret, and appreciate the significance of specific formations. For a more complete, in-depth discussion of price patterns, their underlying psychology, and significance, please refer to Martin Pring on Price Patterns (McGraw-Hill, 2005).

  The concept of price patterns is demonstrated in Figures 8.1 and 8.2. Figure 8.1 represents a typical market cycle in which there are three trends: up, sideways, and down. The sideways trend is essentially a horizontal or transitional one, which separates the two major market movements.

  FIGURE 8.1 Top and Bottom Reversals

  FIGURE 8.2 Reversal on a Dime

  Sometimes, a highly emotional market can change without warning, as in Figure 8.2, but this rarely happens. Consider a fast-moving train, which takes a long time to slow down and then go into reverse; the same is normally true of financial markets.

  To the market technician, the transitional phase has great significance because it marks the turning point between a rising and a falling market. If prices have been advancing, the enthusiasm of the buyers has outweighed the pessimism of sellers up to this point, and prices have risen accordingly. During the transition phase, the balance becomes more or less even until finally, for one reason or another, it is tipped in a new direction as the relative weight of selling pushes the trend (of prices) down. At the termination of a bear market, the reverse process occurs.

  Major Technical Principle Transitions between a rising and a falling trend are often signaled by identifiable trading ranges known as price patterns.

  These transition phases are almost invariably signaled by clearly definable price patterns or formations whose successful completion alerts the technician to the fact that a reversal in trend has taken place.

  This phenomenon is illustrated in Figure 8.3, which shows the price action at the end of a long rising trend. As soon as the price rises above line BB, it is in the transitional area, although this is apparent only sometime after the picture has developed.

  FIGURE 8.3 Trading Range Reversal

  Once into the area, the price rises to line AA, which is a resistance area. The word “resistance” is used because at this point the price shows opposition to a further rise. When the demand/supply relationship comes into balance at AA, the market quickly turns in favor of the sellers because prices react. This temporary reversal may occur because buyers refuse to pay up for a security, or because the higher price attracts more sellers, or for a combination of these two reasons. The important fact is that the relationship between the two groups is temporarily reversed at this point.

  Following the unsuccessful assault on AA, prices turn down until line BB, known as a support level, is reached. Just as the price level at AA reversed the balance in favor of the sellers, so the support level BB alters the balance again. This time, the trend moves in an upward direction, for at BB, prices become relatively attractive for buyers who missed the boat on the way up, while sellers who feel that the price will again reach AA hold off. For a while, there is a stand-off between buyers and sellers within the confines of the area bounded by lines AA and BB. Finally, the price falls below BB, and a major new (downward) trend is signaled.

  To help explain this concept, the contest between buyers and sellers is like a battle fought by two armies engaged in trench warfare. In Figure 8.4, example a, armies A and B are facing off. Line AA represents army A’s defense, and BB is army B’s line of defense.

  FIGURE 8.4 Trench Warfare

  The arrows indicate the forays between the two lines as both armies fight their way to the opposing trench but are unable to penetrate the line of defense. In the second example, army B finally pushes through A’s trench. Army A is then forced to retreat and make a stand at the second line of defense (line AA2). In the markets, line AA represents selling resistance, which, once overcome, signifies a change in the balance between buyers and sellers in favor of the buyers, so that prices will advance quickly until new resistance is met. The second line of defense, line AA2, represents resistance to a further advance.

  On the other hand, army B might quite easily break through AA2, but the further it advances without time to consolidate its gains, the more likely it is to become overextended and the greater is the probability of its suffering a serious setback. At some point, therefore, it makes more sense for this successful force to wait and consolidate its gains.

  If prices extend too far without time to digest their gains, they, too, are more likely to face a sharp and seemingly unexpected reversal.

  Introducing the Rectangle

  The transitional or horizontal phase separating rising and falling price trends discussed earlier is a pattern known as a rectangle. This corresponds to the “line” formation developed from Dow theory. The rectangle in Figure 8.5, marking the turning point between the bull and bear phases, is termed a reversal pattern.

  FIGURE 8.5 Downside Breakout Signal

  Reversal patterns at market tops are known as distribution areas or patterns (where the security is “distributed” from strong, informed participants to weak, uninformed ones), and those at market bottoms are called accumulation patterns (where the security passes from weak, uninformed participants to strong, informed ones. In Figure 8.6 we see a completed pattern with a victory for the buyers as the price pushed through line AA.

  FIGURE 8.6 Upside Breakout Signal

  Note that as the price moves through AA, the series of declining peaks and troughs reverses to one of rising peaks and troughs. On the other hand, in Figure 8.7, the price breaks to the upside, reinforcing the series of rising peaks and troughs that precede the formation of the rectangle, thereby reaffirming the underlying trend.

  FIGURE 8.7 Upside Continuation Breakout Signal

  In this case, the corrective phase associated with the formation of the rectangle would temporarily interrupt the bull market. Such formations are referred to as consolidation or continuation patterns. An example of a bearish continuation rectangle is shown in Chart 8.1 for the copper price and Chart 8.2 for the Dow Jones Rail Average.

  CHART 8.1 Copper Featuring a Consolidation Rectangle

  CHART 8.2 Dow Jones Rail Average 1946. This chart shows a classic rectangle as traced out by the Dow Jones Ra
il Average at the peak of the 1942–1946 bull market. Note the declining trend of volume as reflected by the declining dashed line during the formation of the rectangle. Worth special attention is the saucer like formation of the volume during the late July to early August rally. The expansion of activity accompanying the downside breakout in late August signals the successful completion of this pattern.

  During the period of formation, there is no way of knowing in advance which way the price will ultimately break; therefore, it should always be assumed that the prevailing trend is in existence until it is proved to have been reversed. Figure 8.8 shows an example of a continuation rectangle that develops in a downtrend.

  FIGURE 8.8 Downside Continuation Breakout Signal

  Size and Depth

  The principles of price pattern construction and interpretation can be applied to any time frame, right from one-minute bars all the way through to monthly or even annual charts. However, the significance of a price formation is a direct function of its size and depth.

  Major Technical Principle The longer a pattern takes to complete, and the greater the price fluctuations within it, the more substantial the following move is likely to be.

  Thus, a pattern that shows up on a monthly chart is likely to be far more significant than one plotted with intraday data and so forth. It is just as important to build a strong base from which prices can rise as it is to build a large, strong, deep foundation upon which to construct a skyscraper. In the case of financial market prices, the foundation is an accumulation pattern that represents an area of indecisive combat between buyers and sellers. The term “accumulation” is used because market bottoms always occur when the news is bad. In markets, such an environment stimulates sales by uninformed investors who were not expecting developments to improve. During an accumulation phase, more sophisticated investors and professionals would be positioning or accumulating the asset concerned in anticipation of improved conditions for the security in question six to nine months ahead. During this period, the security in question is moving from weak, uninformed traders or investors into strong and knowledgeable ones. At market tops, the process is reversed, as those who were accumulating at or near the bottom sell to less sophisticated market participants, who become more and more attracted as prices rise. For equities, this might develop because business conditions improve and forecasts for the economy are revised upward. Thus, the longer the period of accumulation, the greater the amount of a security that moves from weak into strong hands, and the larger is the base from which prices can rise. The reverse is true at market tops, where a substantial amount of distribution inevitably results in a protracted period of price erosion or base building.