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Prepared and published by

CSI

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Technical Analysis Course

Where leaders learn financial services.

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CSI GLOBAL EDUCATION INC. (2008) i

Contents

Introduction .............................................................................Int1

1 An Overview of Technical Analysis............................................. 11

What is Technical Analysis? ................................................................................14

Technical vs. Fundamental Analysis................................................................... 14

Technical Analysis Methodologies .....................................................................16Chart Analysis ............................................................................................................. 16

Quantitative Analysis ................................................................................................... 16

Sentiment Analysis....................................................................................................... 16

Cycle Analysis .............................................................................................................. 17

Benefits of Technical Analysis ............................................................................. 17

Market Timing ............................................................................................................ 17

Price Forecasting .......................................................................................................... 19

Leading Indicator ..................................................................................................... 110

A Final Word ..................................................................................................... 111

Chapter Summary ............................................................................................112

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CSI GLOBAL EDUCATION INC. (2008)

TECHNICAL ANALYSIS COURSEii

2 Methods of Charting ................................................................. 21

Benefits of Charting ........................................................................................... 24

Bar Charts ...........................................................................................................24

Line Chart (or Close-Only Chart) .................................................................... 26

Candlestick Charts ............................................................................................. 27

Point and Figure Charts ............................................................................................... 29

Chart Creation .......................................................................................................... 210

Chart Scaling .....................................................................................................213

Chapter Summary ............................................................................................215

3 Trend Analysis ............................................................................ 31

Dow Theory .........................................................................................................34

The Averages Discount Everything .............................................................................. 35

The Market has Three Trends ...................................................................................... 35

Primary Trends Have Three Phases .............................................................................. 36The Averages Must Confirm Each Other ..................................................................... 39

Volume Must Confirm the Trend ............................................................................... 311

A Trend Should be Assumed to Persist Until it Gives Definite Signals

that it has Reversed ................................................................................................... 313

Support and Resistance Levels ........................................................................314

Horizontal Support and Resistance ............................................................................ 314

Market Profile ............................................................................................................ 316

Trendlines ..........................................................................................................318

Construction of Trend Channels ......................................................................321

Fan Lines ............................................................................................................323

Chapter Summary ............................................................................................324

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CONTENTS iii

4 Chart Formations and Projections .............................................. 41

Reversal Patterns ................................................................................................ 44

Key Reversals ....................................................................................................... 44

Head-and-Shoulders Formations ...................................................................... 46

Head-and-Shoulders Top Formation ............................................................................ 46

Estimating Price Objectives ......................................................................................... 48

Multiple Head-and-Shoulders Formations ................................................................... 48

Head-and-Shoulders Bottom Formation ...................................................................... 49

Double Tops and Bottoms ......................................................................................... 411

Rounded Tops and Bottoms ............................................................................. 413

V Formations .....................................................................................................414

Island Reversals .......................................................................................................... 415

Continuation Patterns ......................................................................................417

Triangles ............................................................................................................. 417

Symmetrical Triangle ................................................................................................. 418

Ascending Triangle ..................................................................................................... 420

Descending Triangle .................................................................................................. 422

Inverted Triangles and Broadening Tops..................................................................... 424

Wedges ..............................................................................................................425

Flags and Pennants ...........................................................................................427

False Breakouts .................................................................................................430

Chapter Summary ............................................................................................432

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TECHNICAL ANALYSIS COURSEiv

5 Candlestick Chart Formations ................................................... 51

The Benefits of Candlestick Charting .............................................................. 54

Candlestick Reversal Patterns ........................................................................... 54

Doji Candlestick .......................................................................................................... 54

Morning and Evening Stars.......................................................................................... 56

Dark Cloud Cover and Engulfing Patterns ................................................................... 58

Piercing Pattern ......................................................................................................... 511

Hammer and Hanging Man ..................................................................................... 512

Harami Pattern .......................................................................................................... 514

Tweezers .................................................................................................................... 516

Other Types of Patterns ............................................................................................. 518

Candlestick Continuation Patterns ................................................................. 518

Windows (Gaps) ........................................................................................................ 518

Rising and Falling Three Methods ............................................................................. 520

Chapter Summary ............................................................................................ 523

6 Point and Figure Charting ......................................................... 61

Benefits and Drawbacks of P&F Charts ........................................................... 64

P&F Chart Trendlines and Formations ............................................................. 65

Measured Move ........................................................................................................... 66

Chart Patterns ....................................................................................................67

Fulcrum and Compound Fulcrum ............................................................................... 67

V Base and Inverted V ................................................................................................. 68

Saucer Top and Bottom ............................................................................................... 69

Chapter Summary ............................................................................................ 611

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CONTENTS v

7 Quantitative Analysis ................................................................. 71

Quantitative Indicators ...................................................................................... 74

Trend-Following Indicators ................................................................................74

Moving Averages .......................................................................................................... 74

Bollinger Bands and Moving Average Envelopes ........................................................ 710

Average True Range (ATR) and Directional Movement Index (DMI) ........................ 712

Momentum Indicators......................................................................................713Moving Average Convergence-Divergence (MACD) .................................................. 713

Momentum and Rate of Change (ROC) ................................................................... 716

Stochastics ................................................................................................................. 720

Relative Strength Index (RSI) .................................................................................... 722

Other Oscillators ....................................................................................................... 726

Chapter Summary ............................................................................................ 727

8 Time Cycles ............................................................................... 81Introduction to Cycles ........................................................................................ 84

Cycles in Nature .................................................................................................85

Cycles and Market Timing.................................................................................. 85

The Structure of Cycles ..................................................................................... 86

Peaks and Troughs ....................................................................................................... 86

Cycle Structure ............................................................................................................ 87

Cycle Principles ........................................................................................................... 89

Synchronicity ............................................................................................................. 810

Harmonicity .............................................................................................................. 810

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TECHNICAL ANALYSIS COURSEvi

Prominent Cycles .............................................................................................811

The Kondratieff Cycle ............................................................................................... 812

The Jugular Cycle ...................................................................................................... 814

The Kitchin Cycle ..................................................................................................... 814

Decennial Pattern ...................................................................................................... 815

Nine-Month Cycle..................................................................................................... 816

The January Effect ..................................................................................................... 817

Seasonal Cycles .......................................................................................................... 817

Intermarket Cycles ..................................................................................................... 817

KST (Know Sure Thing) ............................................................................................ 818

Combining Cycle Analysis with Other Technical Analysis Tools ................... 819

Chapter Summary ............................................................................................ 821

9 Intermarket Analysis .................................................................. 91

What is Intermarket Analysis? ..........................................................................94Basic Framework of Intermarket Analysis..................................................................... 96

Key Relationships and Basic Principles......................................................................... 97

The Business Cycle ........................................................................................... 911

Tracking the Business Cycle ....................................................................................... 912

The Business Cycle and Relative Stock Market Performance ...................................... 913

The Fed and the Business Cycle ................................................................................. 917

Equity Sector Rotation ..................................................................................... 918

Consumer Sectors ...................................................................................................... 920

Inflationary and Disinflationary Environments .......................................................... 921

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CONTENTS vii

Portfolio Application .........................................................................................923

Top-down and Bottom-up Analysis ........................................................................... 923

Applying Intermarket Analysis ................................................................................... 923

ETFs or Stocks? ......................................................................................................... 927

Managing the Portfolio .............................................................................................. 928

Chapter Summary ............................................................................................930

10 Elliott Wave Theory ............................................................... 101

Elliott Wave Theory Background.....................................................................104

Elliotts Assumptions ........................................................................................ 104

The Basic Structure of Price Patterns ............................................................ 105

Impulse Waves, Extensions and Variations .....................................................109

Corrections ......................................................................................................1013

Zigzag Corrections ................................................................................................... 1014

Flat Corrections ....................................................................................................... 1015Triangle, Double Three and Triple Three Corrections .............................................. 1018

Rules and Guidelines ......................................................................................1018

Enhancing Elliott .............................................................................................1019

Wave Characteristics/Personalities ..............................................................1020

Relationship of Basic Chart Analysis and Elliott Wave ................................ 1021

Chapter Summary ..........................................................................................1022

11 Technical Analysis of Equity Markets ..................................... 111

Overall Equity Market Analysis .......................................................................114

Trend ......................................................................................................................... 114

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TECHNICAL ANALYSIS COURSEviii

Breadth ...................................................................................................................... 114

Volume ...................................................................................................................... 119

Momentum ............................................................................................................. 1111

Sentiment ................................................................................................................ 1112

Sector Analysis ................................................................................................1115

Individual Stock Selection........................................................................................ 1117

Chapter Summary ..........................................................................................1118

12 Technical Analysis of Futures Markets .................................... 121

Unique Characteristics of Futures Markets ................................................... 124

Market Timing ...................................................................................................124

Long-Term Charts ............................................................................................125

Nearby Charts ........................................................................................................... 127

Continuous Contract Charts ........................................................................... 128

Continuous (Spread-Adjusted) Charts ....................................................................... 129

Seasonality and Cycles ...................................................................................1210

Volume and Open Interest ............................................................................ 1211

Commitments of Traders Report .................................................................1213

Bullish Consensus Index .................................................................................1214

Chapter Summary ..........................................................................................1215

13 Putting It All Together ........................................................... 131

Formulating a Trading Plan .............................................................................. 134

Analyzing the Overall Health of the Market .............................................................. 135

Picking the Right Sector ............................................................................................ 138

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CONTENTS ix

Picking the Right Stock ............................................................................................ 139

Studying the Charts of Selected Stocks ...................................................................... 139

Determining Low-Risk Entry Points and Profit Objectives ...................................... 1310

Being Well Capitalized ................................................................................... 1310

Understanding the Markets You Are Trading ............................................... 1311

Money Management Rules .............................................................................1311

Look for Trades Where the Profit Potential is at Least Three

Times the Loss Potential .......................................................................................... 1311

Always Use a Stop-Loss Order or an Appropriate Option to Limit Your Risk........... 1312

Never Alter Your Stop-Loss Levels to Permit Greater Losses ..................................... 1312

Do Not Add to Your Position Until You Can do so Without Increasing Your

Original Risk ........................................................................................................... 1312

Do Not Trade Against the Trend .............................................................................. 1313

Limit the Size of Your Losses .................................................................................... 1313

Trade With Money That You Can Afford to Lose .................................................... 1313Be Patient and Wait for Good Trading Opportunities .............................................. 1313

Reduce Position Size When you Find Yourself in the Midst of a Losing Streak ......... 1313

Make Your Own Trading Decisions ......................................................................... 1314

Dont Base Trading Decisions on Tax Consequences ................................................ 1314

Be Flexible in Your Trading Approach ...................................................................... 1314

Know Yourself ..................................................................................................1314

Chapter Summary ..........................................................................................1315

Glossary .......................................................................................... G1

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CSI GLOBAL EDUCATION INC. (2008) 1nt1

Introduction

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TECHNICAL ANALYSIS COURSE1nt2

The intent of CSIs Technical Analysis Course is to provide you with a basic understanding ofthe various technical analysis methodologies that are used by professionals and the investing andtrading public alike. This course covers technical analysis of both equity and futures markets, andhow it relates to both short-term traders and longer-term investors.

While this course is comprehensive, it should be viewed as the start of your learning in this field,

not the end. The need for constant study cannot be overemphasized. While this course will giveyou the basic tools to get you started, there is no substitute for experience. You should take whatyou learn in this course to help you define and then refine your own trading or investing style,which should be based on an understanding of your own strengths and weaknesses, your financialsituation and on your study of which indicators work best in which markets.

Chapter 1 of this course gives an overview of technical analysis including its benefits, acomparison with fundamental analysis and a description of the main technical analysismethodologies.

Chapter 2 describes the various methods of charting price data including bar, candlestick, andpoint and figure charts. The advantages and disadvantages of each method are discussed. Adescription of how each of the charts is constructed is presented.

Chapter 3 covers trend analysis. The concept that markets move in trends and that trends tendto persist for relatively long periods of time is at the cornerstone of technical analysis. The oldestand most recognized method of identifying trends, the Dow Theory, is explained, as are theconcepts of trendlines, trend channels, and support and resistance levels.

In Chapter 4 the key topic of chart formations is covered. The major chart reversal andcontinuation formations from head and shoulders to triangles are described. For each formationtalked about, price projections and trading applications are discussed.

Chapter 5 details a specific charting method known as Candlestick Charting. The benefits of thismethod, which goes back to the 1600s, are discussed along with the ways to trade breakouts fromthese formations.

Point and Figure charting is covered in Chapter 6. This method of charting sometimes givesanalysts a perspective somewhat different from a bar or candlestick chart. The unique patternsand measurements of point and figure charting are described.

Chapter 7 describes the use of quantitative statistical indicators, such as moving averages andoscillators, as a supplement to basic chart analysis. Popular indicators such as stochastics andmoving average convergence/divergence (MACD) are discussed.

Cycle analysis is covered in Chapter 8. This chapter describes how the study of cycles can be usedfor the purpose of forecasting potential turning points. Short-term as well as long-term cycles,such as the Kondratieff cycle, are discussed.

Chapter 9 describes intermarket analysis, which studies multiple related asset types in differentmarkets around the world. This includes the traditional equities, bonds, currencies andcommodities, as well as international market and industry indexes. In a world of increasingglobalization, markets are interconnected and impact each other.

Chapter 10 covers Elliot Wave, a theory that concludes that stock market movements can bepredicted by observing and identifying a repetitive pattern of waves.

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INTRODUCTION 1nt3

The unique features of technical analysis applied to equity markets are covered in Chapter 11.Breadth, momentum and sentiment indicators, and how they are used in understanding theoverall health of the market, are described and discussed. Once the health of the overall marketis studied, the trader/investor then must look at specific sectors of the market and then specificstocks. The tools to evaluate sectors and individual stocks are covered.

Chapter 12 covers technical analysis of futures markets and the importance of open interest.As futures contracts offer high degrees of leverage and have short life spans, timing is extremelyimportant.

The course concludes with Chapter 13, which ties together the knowledge contained in theprevious chapters. This leads you through the steps in making an investment decision, includingformulating a trading plan, understanding the markets you are trading, implementing adisciplined approach to money management and very importantly, understanding your ownstrengths and weaknesses.

The glossary at the back of the textbook serves as a reference to the new terms you will belearning throughout the course.

You will expand your knowledge of technical analysis, which should definitely help timingof your investment decisions. You are encouraged to experiment with the different technicalindicators discussed in this course and see what results you get by changing time periods and bypaper trading. Talk to experienced technicians and traders to get their interpretation of indicatorsand how they work in various markets. You may also be interested in the Canadian Society ofTechnical Analysts (www.csta.org), which has chapters in major cities across Canada. The societyoffers lectures, an annual conference, and has one of the worlds most comprehensive libraries oftechnical analysis material.

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CSI GLOBAL EDUCATION INC. (2008) 11

Chapter1

An OverviewofTechnical Analysis

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CSI GLOBAL EDUCATION INC. (2008)12

1

An OverviewofTechnical Analysis

CHAPTER OUTLINE

What is Technical Analysis?

Technical vs. Fundamental Analysis

Technical Analysis Methodologies

Chart Analysis

Quantitative Analysis

Sentiment Analysis

Cycle Analysis

Benefits of Technical Analysis

Market Timing

Price Forecasting

Leading Indicator

A Final Word

Chapter Summary

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LEARNING OBJECTIVES

By the end of this chapter, you should be able to:

1. Understand what technical analysis is.

2. Know the three assumptions upon which technical analysis is based.

3. Understand how technical analysis differs from fundamental analysis.

4. Know the various technical analysis methodologies.

5. Understand the benefits of technical analysis.

KEY TERMS

Behavioral Finance Quantitative analysis

Chart analysis Random Walk Theory

Cycle analysis Sentiment

Efficient Markets Hypothesis (EMH) Sentiment indicator

Leading indicator Technical analysis

Market action

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TECHNICAL ANALYSIS COURSE14

WHAT IS TECHNICAL ANALYSIS?

Technical analysis is the process of analyzing historical market activity and investor behavior inan effort to determine probable future price trends. This encompasses several primary sources of

information available to a technician (technical analyst): price, volume, time, and in the case offutures contracts, open interest.

Technical analysis is based on three assumptions:

1. All influences on market action are automatically accounted for or discounted in priceactivity. Technical analysts believe that all known market influences are fully reflected inmarket prices. They believe there is little to be gained bydoing further fundamental analysis.All that is required is to study the price action itself. By studying price action, the technicianattempts to determine and measure market sentiment and expectations. In effect, thetechnical analyst lets the market do the talking. Through a variety of methods, a technicalanalyst will interpret market action, letting the market indicate the direction and the extent

of its next price move.

2. Prices move in trends and those trends tend to persist for relatively long periods of time.Given this assumption, the primary task of a technician is to identify a trend, preferably in itsearly stages, and carry positions in that direction until the trend has proven to have reverseditself. This is not as easy as it sounds.

3. The future can be found in the past. Technical analysis is the process of analyzing an assetshistorical prices and investors actions to determine probable future prices. Techniciansbelieve that markets are essentially a reflection of mass psychology and that the behaviourof the masses (or the crowd) tends to repeat itself. The crowd tends to fluctuate betweenpessimism, fear and panic on one hand and optimism, greed and euphoria on the other. Bycomparing current crowd behaviour, as reflected through market action, with comparable

historical market behaviour, technicians attempt to predict a reasonable outcome. If historydoes not exactly repeat itself, at least much can be learned from the past.

TECHNICAL VS. FUNDAMENTAL ANALYSIS

One common misconception surrounding technical analysis is that its proponents believe thefundamentals of an underlying asset (i.e., supply anddemand) do not affect the price of the asset.This is far from the truth. In fact, technical analysis is really an indirect study of fundamentals.The major difference between technical and fundamental analysis is that the technician studies

the effectsof supply anddemandthat is, price, volume, sentiment, and open interest overtimewhile the fundamental analyst studies the causesof price movements.

Figure 1.1 illustrates the basic relationship between fundamental and technical analysis. Nomatter what input is driving the market, technicians believe these are fully reflected in priceaction. A fundamentalist will try to understand all the inputs and attach a price forecast based onthose inputs. Many technicians assume the fundamentalists have done their job, leaving nothingto be gained from further study of fundamentals, because all known market influences are alreadyreflected in prices. All that is left to do is study market action through a variety of tools, which

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ONE AN OVERVIEW OF TECHNICAL ANALYSIS 15

will be discussed throughout this course. However, a good technician will be aware of potentialfundamental catalysts, such as the release of earnings announcements, economic or crop reports,etc. The reaction to these events is helpful in understanding the supply anddemand forces.Technicians understand that supply anddemand forces cause prices to fluctuate; they just do notbelieve that knowing the precise nature of those forces adds much to the forecasting process.

FIGURE 1.1 RELATIONSHIP BETWEEN FUNDAMENTAL ANALYSIS AND TECHNICAL ANALYSIS

GDPFOMCBOC CPI

Event Risk Budgets

Global Interest Rates

Supply

Demand

Volume

Price

GDPFOMCBOC CPI

Event Risk Budgets

Global Interest Rates

Supply

Demand

Volume

Price

Technical analysis is essentially a time study of price and volume. At any point in time, the price of a

security is determined by the relationship between the supply and demand for that security. Fundamental

analysis is the study of information, such as Gross Domestic Product (GDP) or the Consumer Price Index

(CPI), which can potentially affect the supply and demand of a security.

Where a fundamental analyst may suggest a bull market in equities will continue because interestrates are falling, a technical analyst would say that newhighs in equities are likely to continue

because of the bullish momentum in the bond market. Where a fundamental analyst wouldlower earnings expectations after a companywarns of poor revenues due to its negative currencyexposure in South East Asia, a technical analyst would see the downward shift in the stocks pricemomentum and suggest selling it.

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TECHNICAL ANALYSIS METHODOLOGIES

Technical analysis is not about crystal balls and get-rich-quick schemes. To master technicalanalysis, it takes years of studying to develop a skill in reading price action and to knowwhich

indicators work best in which markets. Even then, the success of many technical trading systemsrelies on expert money management rules and execution skills.

The methods used by a technician to identify trends and possible trend turning points can bedivided into four broad categories: chart analysis, quantitative analysis, analysis of sentimentindicators and cycle analysis. They are often used in conjunction with each other.

Chart Analysis

Chart analysis is the use of graphical representations of anydata that could potentially berelevant to analyze a market trend. The purpose of a chart is to get a visual sense ofwhere themarket has been in order to try to project where it may be going. The most common type of

chart is one that graphs the high, lowand close (or last trade) of a particular security (stock,market average, commodity, etc.) over a given timeframe, such as hourly, daily, weekly, monthlyor even yearly. This type of chart is referred to as a bar chart, and often has the correspondingvolume appearing at the bottom. Other price charts that will be discussed are candlestick charts,line charts, and point and figure charts.

The Dowtheory is probably the oldest and best-known charting technique for identifying majortrends in stock market averages. The theory evolved from a series of editorials written by CharlesDowwho founded the DowJones Financial News Service and is generally creditedwith thefounding of stock market averages. Dows editorials were eventually organized and formulatedinto the DowTheory, which still forms the basis for chart analysis to this day. The Dowtheorywill be discussed in detail in Chapter 3.

Quantitative Analysis

Quantitative analysis is a form of technical analysis that has been greatly enhanced by thegrowing sophistication of computers. There are two general categories of statistical tools: movingaverages and oscillators. They are used to supplement chart analysis, either by identifying (orconfirming) trends, or by giving an earlywarning signal that a particular trend is starting to losemomentum, and may therefore change.

Sentiment Analysis

Sentimentis the emotion or psychology of investors. This both affects market action and isaffected by market action. Sentiment indicators focus on investor expectations. Contrarianinvestors use these indicators to determine what the majority of investors expect prices to doin the future, and they then do the opposite. The rationale behind contrarian investing is thetheory of contrarian opinion, which suggests that when a majority (the crowd) is in agreement,they are usuallywrong. Applying this to technical analysis, for example, if the vast majority ofinvestors feel that prices will rise, then there probably is not enough buying power left to pushprices much higher. The concept is well proven, especially at market tops and bottoms, and isused to support other technical indicators (oscillators).

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Cycle Analysis

The tools described above help technical analysts forecast a markets most probable direction andthe extent of the move. Cycle analysis helps forecast when the market will start moving in thatdirection andwhen the ultimate peak or trough will be achieved.

Cycles can last for short periods of time such as a fewdays, to decades. What makes cycle

analysis complicated is that at any given point in time there may be a number of cycles operatingconcurrently.

Cycle analysis is used to accurately predict events in nature: bird migrations, the tides, planetarymovements, seasons, etc. The prices of many commodities, particularly in the agriculturecomplex, reflect seasonal cycles as well. The task of applying cycles to financial assets, however,is more complex. Later in this course we will discuss the four general categories of cycle lengths:long-term (more than 2 years), seasonal (1 year), intermediate (9 to 26 weeks), and trading(4 weeks).

BENEFITS OF TECHNICAL ANALYSIS

Technical analysis is used to improve market timing, forecast price movements and, mostimportantly, indicate potential turning points before they occur (i.e., act as a leading indicator).These applications are particularly important when using leverage.

Market Timing

Fundamental analysts try to understand the micro and macro events that influence the supplyanddemand of a particular asset. With respect to equities, for example, the analyst has an in-depth understanding of a companys key balance sheet and income statement items, competitivesituation anddemand trends for its products. Overlaid on this is an understanding ofmacroeconomic factors such as economic growth, inflation and employment trends.

While having a solid understanding of all these factors is important, it does not ensure successfulmarket timing. In fact, many fundamental analysts are quite poor market timers because theytend to ignore the behavioural aspect of supply anddemand analysis. We have probably all seensituations where a strong buy recommendation is given at a certain price level, only to see theprice of the stock go in the opposite direction. (The common reaction to this situation is that ifthe stockwas a great buy at the recommended price, it is even a better buy at the lower price!)

The reason this happens often has little to do with the quality or accuracy of the analysts work.It has everything to do with the fact that markets discount information very quickly. The

fundamental analyst may have been correct in the analysis, but the market may have alreadypriced in the same information. Another possibility is that the analyst may be too far aheadof the market. The forecast may come true in the long run, but that doesnt help the investorwho has seen prices move, at least in the short-term, in a direction opposite to the forecast andhas experienced a large loss. This is particularly frustrating if the loss is on a futures or optionscontract, both ofwhich have limited lives and use a considerable amount of leverage.

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One of the benefits of technical analysis is the timing of market entry and exit points. Asmentioned above, this is particularly important for derivative instruments, since a buy-and-holdstrategy is not viable when it comes to trading these. Due to the instruments limited time toexpiration and leverage, timing is an essential part of the investment decision process, if not themost important (see Figure 1.2). Despite a consensus that the Canadian dollar was undervaluedbased on Canadas low inflation, moderate growth and balanced budget environment, the

Canadian dollar went into a rapiddecline against most of the major world currencies, particularlythe U.S. dollar. Many market participants and the press reported that its gone too far too fastand its very cheap at these levels. Trying to pick a bottom in a falling market, however, is liketrying to catch a falling knife.

FIGURE 1.2 IMPORTANCE OF MARKET TIMING - CANADIAN DOLLAR FUTURES

Canadian dollar in a near free fall which saw the currency decline from US$0.71 to under US$0.64 during

the first half of 1998.

The proper use of basic technical analysis trend-following tools would have kept a currencytrader on the short side of the market, or at least would have prevented a premature purchase. Ifone futures contract was purchasedwhen the dollar was considered cheap at US$0.68, the tradewould have lost over 700% on the margin deposit by the time the Canadian dollar hit US$0.64,only eight weeks later. No small investor can regularlywithstand that kind of loss, and largeinvestors will become small ones pretty quickly by holding onto trades like that.

Canadian o ar in near free fall w ic saw t e currency ec ine from US$0.71 to un er US$0.64 uring

t e irst hal o 1 .

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This example is meant to emphasize the importance of understanding the difference betweenanalysis and timing, not to compare the effectiveness of technical analysis versus fundamentalanalysis. Studying the fundamentals (and the long-term technicals) can give an investor a senseof the long-term price prospects for an asset, which might be the first step in an investmentdecision-making process. However, when one gets further into the decision-making process to thepoint ofdeciding when and at what level to actually enter or exit a market, technical analysis is

essential, particularlywhen trading derivative contracts.

Price Forecasting

The stock market is an auction market affected by crowd psychology and the alternatingemotions of confidence and fear, and in the extreme, greed and panic. The overall trend of moneyflowing in or out of the market is what affects equity prices. Charts, the technicians primary tool,can reveal at a glance the effect that market psychology is having on the flowof money into orout of a stock. The true, or intrinsic, value of a stock is rarely known with certainty. The marketprice moves above and belowthis intrinsic value, pushed and pulled by market psychology.

It would be difficult enough to try to forecast what an asset is worth, or going to be worth in the

future, if markets priced in a perfectly logical fashion (i.e., based on actual value). The fact thattheydo not makes the challenge of price forecasting that much more difficult. As the saying goes,a stock is rarely priced at what it is reallyworth, but at what people thinkit is worth. Techniciansbelieve that it is not enough to merely understand the supply anddemand fundamentals to comeup with a price forecast. One also has to think about howthe crowd will react, since a stock orany asset is onlyworth what someone is willing to pay for it.

By studying past market behaviour and comparing it with current market action, technicalanalysis can help identify trends and turning points, and project the extent of price movementsthrough the analysis of price patterns and breakouts from these patterns.

One such pattern, which will be discussed later in more detail, is the head-and-shoulders

formation. This formation, which occurs at both market tops and bottoms, is one of the mostreliable of all chart patterns. Completion of the formation gives the analyst not only an indicationof a change in trend, but also some idea of the size of the subsequent price move (see Figure 1.3).The pattern consists of a rally to a newhigh or low(the head) separating two smaller rallies (theshoulders). The completion of the formation for a head-and-shoulders top occurs when the line(neckline) connecting the troughs of the first shoulder and head rallies is violated after the rightshoulder is completed. The price objective, or forecasted price target, is found by taking theheight of the pattern (the vertical distance between the top of the head and the neckline) andprojecting it from where the neckline is broken.

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FIGURE 1.3 HEAD-AND-SHOULDERSTOPAND FORECASTED PRICETARGET

A head-and-shoulders formation in the silver futures market. Head-and-shoulders formations are one

of the most reliable of all reversal patterns, which are used to detect a change in the trend of a market.

Leading Indicator

Technical analysis assumes that all known market information is alreadydiscounted in an assetsprice. Often, however, prices move in a way that is inconsistent with the known fundamentals.This is a signal that the market is reacting to unknown information, and can happen when amarket starts to discount a change in the fundamentals well before it actually takes place. Thishappens quite frequently in the early stages of a bull or bear market, often in a dramatic andexplosive fashion. When this occurs, technical analysis can be used as a leading indicator,meaning the price action is essentially predicting what will happen to the assets fundamentals in

he future. In the face of this unusual price activity, market participants who faithfully followthefundamentals maywant to revisit their analysis.

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A FINAL WORD

Although this course will cover a multitude of technical indicators, keep in mind that thereis no easy and surefire way to accurately forecast prices. As a matter of fact, in the academic

community, critics of technical analysis believe it is worthless. They often cite the Random WalkTheory and the Efficient Markets Hypothesis (EMH) to support this conclusion. The RandomWalk Theorybasically states that price action is independent and random. The EfficientMarkets Hypothesis (EMH) states that market prices fully reflect all available information, andthese prices randomly fluctuate around an intrinsic value.

If these theories are correct, there is no history in price action to produce patterns, there is nopredictive power to technical analysis, and indeed markets should not display observable trends!It would be impossible to beat the market. However, certain chart patterns have been occurringfor hundreds of years, successful money managers consistently outperform the market, and thereis definitely a downward trend in prices after a market crash.

The inability of trad

itional financial theories to explain these and

other market phenomena suchas bubbles and irrational investor behavior, has given rise to Behavioral Finance, which studiesthe psychology of market participants. This psychological influence on investors behavior and itsresult on market action help explain why markets are inefficient and exploitable.

Technical analysis is all about hardwork and understanding which indicators work best in whichmarkets. It is important to realize that most technical analysis concepts and tools (indicators) canbe applied to charts ofdifferent timeframes (daily, weekly, monthly, yearly) as well as differentmarkets (stock, currency, futures, international, etc.). Also, since technical analysis is the studyof historical price action and the investors behavior driving it, chart patterns, trend changes or amarkets reaction to event shocks are extremely similar in data from the 1920s, 1990s or today.This is because fundamental human psychology and behavior has remained quite consistent,despite the advent of the computer age.

Even if forecasting accuratelywere easy, it would be no guarantee of success. Anyone who has evertraded understands that being ultimately correct in your forecast is no compensation for losingmoney because your timing was off or because proper money management practices were notused. A successful trading plan requires:

accurate forecasting;

excellent timing (particularly in leveraged financial instruments such as futures and options);and

proper money management techniques.

Each of these components will be discussed in this course.

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CHAPTER SUMMARY

In this chapter, you learned about:

1.W

hat technical analysis is Technical analysis is the process of analyzing historical market action in an effort to

determine probable future price trends.

Market action encompasses three primary sources of information: price, volume andtime.

When performing technical analysis on futures contracts, open interest is often analyzedfor further insight.

2. The three assumptions upon which technical analysis is based

Technical analysis is based on the following three assumptions:

All influences on market action are automatically accounted for, or discounted, inprice activity.

Prices move in trends and those trends tend to persist for relatively long periods oftime.

The future can be found in the past.

3. Howtechnical analysis differs from fundamental analysis

Technical analysis studies the effects of supply anddemand on a particular asset ormarket (i.e., price andvolume), while fundamental analysis studies the cause of changes

in supply anddemand.

Technicians assume that all known market influences are reflected in prices, andtherefore believe that all that is left is to study market action itself.

4. The various technical analysis methodologies

Chart analysis is the study of graphical representations of any market data that may berelevant in determining market trends and changes in trends.

Quantitative analysis is the mathematical manipulation of market data to help in theidentification or confirmation of market trends.

Analysis of sentiment ind

icators,w

hich tend

to be used

as contrarian signals, helpdetermine what the majority of investors expect prices to do in the future.

Cycle analysis attempts to uncover repetitive patterns in the price of an asset, and it usesthis information to predict future price movements.

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5. The benefits of technical analysis

Technical analysis is used to improve market timing, to help forecast price movements,and to act as a leading indicator.

Market timing helps determine market entry and exit points.

Forecasting price movements helps determine trends and trend turning points.

Leading indicators point to changes in a market trend before the fundamentals reflectthe change.

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Chapter2

Methods of Charting

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2

Methods of Charting

CHAPTER OUTLINE

Benefits of Charting

Bar Charts

Line Chart (or Close-Only Chart)

Candlestick Charts

Point and Figure Charts

Chart Creation

Chart Scaling

Chapter Summary

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LEARNING OBJECTIVES


1. Understand the benefits of charting.

2. Know how to construct and read bar and line charts.

3. Know how to construct and read candlestick charts.

4. Know how to construct and read point and figure charts.

KEY TERMS

Arithmetic scale Measured move

Bar chart Point and figure chart

Box size Real body

Candlestick chart Reversal size

Line chart Semi-log (or logarithmic) scale

Lower shadow Upper shadow

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BENEFITS OF CHARTING

Most aspects of technical analysis involve the interpretation of charts. Categories of chartingtechniques include bar, line, candlestick and point and figure charts. The concept of measuring

open, high, low and close (OHLC) is key to understanding almost all charting techniques. Aswell, most technical indicators that are derived from price data will use some component ofOHLC in the calculation.

Charts are the foundation of technical analysis. Although interpretation may at times besubjective, a chart is a graphic representation of historical market action (price, volume and openinterest) and does not lie. Charts provide a visual picture of where an assets price has been, whichtechnicians believe can then be used to forecast where it may go in future. Think of this is aswhere the asset is today relative to how it has traded historically. Is it higher, lower or the samerelative to previous peaks and troughs? These are the very basics of trend analysis, a primary toolfor a technical analyst.

Charts provide the following benefits: They illustrate price history in a concise and readily understood way.

They act as a leading indicator by providing an early warning signal that fundamentalchanges may be taking place.

They help identify repetitive price patterns and measured moves out of those price patterns. Ameasured move is a price objective or the price level that an asset is expected to achieve basedon a chart formation.

They can help determine entry and exit points, providing a trader with high-reward, low-risktrades.

They can help a trader be more mechanical and objective when trading (i.e., less emotional).

BAR CHARTS

The most commonly used price chart is the bar chart. Each periods action is represented by avertical bar, with the top representing the high for that period and the bottom representing thelow. The bar chart is also known as an open, high, low, close (OHLC) chart, as not only are thehigh and low for the period represented, but also the open and close. A short horizontal line tothe left of the bar represents the open, while the close is a short horizontal line to the right ofthe bar. Figure 2.1 shows a simple bar chart. Notice that the charts vertical axis represents price,while its horizontal axis shows time.

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TWO METHODS OF CHARTING 25

FIGURE 2.1 DAILY BAR CHART - S&P 500

A daily bar chart of the S&P 500 Index from September 26 to October 16, 1998. The box at the bottom of

the chart expands the information represented by the October 8th bar, giving the exact numbers for the

open, high, low and close.

At the bottom of most bar charts is the volume and, in the case of futures contracts, openinterest as well. For stocks, volume represents the total number of shares traded on a given day;for futures, it represents the total number of futures contracts traded. Open interest is the totalnumber of contracts outstanding (still open, or not closed out) at the end of the trading session.Since one futures contract is comprised of a long and a short position, open interest is the totalof either outstanding long or short positions, notthe total of longs and shorts. Open interest, andhow it is used in the technical analysis of futures markets, is explained in detail in Chapter 12.

Both volume and open interest are plotted at the bottom of bar charts so they can be easily

compared with each other and with the price action. Technicians will typically look to volumeand open interest to provide confirmation of significant moves in prices, such as breakouts.

A daily bar chart of the S&P 500 Index from September 26 to October 16, 1998. The box at the bottom of

the chart expands the information represented by the October 8th bar, giving the exact numbers for the

open, high, low and close.

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LINE CHART (OR CLOSE-ONLY CHART)

Aline chartdiffers from a bar chart in that only closing prices are shown. A line connects closeto close movements. Comparing Figure 2.2 with Figure 2.1 shows much more information on

the bar chart than on the line chart, and that information is critical. For example, on October 8ththe close-only chart shows prices falling slightly from the previous days trading session. However,the OHLC chart tells a more detailed story: prices opened at the same level as the previous daysclose (970.68) before falling sharply to an intraday low of 923.32, but finally closing in the upperend of the trading range.

FIGURE 2.2 DAILY LINE CHART - S&P 500

This line chart covers the same time period as the chart in Figure 2.1. Line charts display information

about closing price levels, not intraday action.

Knowing the highs and lows on a particular day is essential when trading, particularly in highlyleveraged instruments such as futures contracts. A stop-loss order1 is normally better placed justunder a significant intraday low (in the case of a long position) or just over the intraday high (inthe case of a short position), rather than just under or over the daily close. Significant intradayhighs and lows are crucial to identify. Violations of these levels could have very bearish (in thecase of a break under a key intraday low) or bullish (a break over an intraday high) implications.For example, for long positions it is normally a break under a key intraday low rather than a

This line chart covers the same time period as the chart in Figure 2.1. Line charts display information

about closing price levels, not intraday action.

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closing low, which signals that prices will likely be heading lower and that it is time to cut losses.The concept of buying support and selling resistance will be covered in depth later in this course.

CANDLESTICK CHARTS

Candlestick charts are one of the oldest charting techniques, dating back to the 1600s.Originally used by Japanese rice farmers for keeping track of crop prices, they add another, morevisual dimension to the Western art of chart analysis.

Both the bar and candlestick chart have four components, the open, high, low and close. Themain difference between the construction of the two charting methods is that candlestick chartshave a real body,which is a box that visually represents the difference between the tradingsessions open and close. This relationship is most important when reading a candlestick becausethe opening and closing price represent a consensus of value. The real body is white (empty) orgreen when the close is higher than the open, and black (filled in) or red when the open is higher

than the close (these are the most common colors candlesticks are displayed in). Figure 2.3 showsthe key components of a candlestick chart. The lines extending from either end of the real bodyare shadows. The upper shadowextends to the highest price, while the lower shadowextends tothe lowest price.

FIGURE 2.3 CANDLESTICK CHART COMPONENTS

The highest price (upper shadow)

The opening or closing price, whichever is greater.

The centre section (real body) is filled in if the close

is lower than the open. Otherwise, it is left empty.

The opening or closing price, whichever is less.

The lowest price (lower shadow)

The size of the real body is key to analyzing candlestick charts. Small real bodies represent atug-of-war, as the change in price from open to close is very small. Conversely, a very long realbody suggests there has been a significant change in the consensus of value, and therefore the

The highest price (upper shadow)

The opening or closing price, whichever is greater.

The centre section (real body) is filled in if the close

is lower than the open. Otherwise, it is left empty.

The opening or closing price, whichever is less.

The lowest price (lower shadow)

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interpretation is more significant. The two shadows, the upper shadow and the lower shadow, areusually considered intraday noise.

Candlestick charts are designed to give market participants price patterns that are easilyrecognizable as either bullish or bearish and represent either a change or a continuation of trend.Figure 2.3 showed an example of a bearish formation, as prices opened near the high of the

trading session and closed significantly lower, near the sessions low.Japanese traders gave the candlesticks themselves and the formations they make colourful names.Due in part to the military Japanese feudal system during this era, candlestick formationswere given names such as counterattack lines and the advancing three soldiers. Just as skill,strategy and psychology are important in battle, so too are they important elements in trading.One such formation gives traders a possible early warning of a market reversal and is known as ahanging man at market tops (and a hammerat market bottoms), see Figure 2.4. This formationusually occurs after a significant trend. Other key candlestick formations, patterns and theirinterpretation will be discussed in Chapter 5. Notice in Figure 2.5 the numerous forms individualcandlesticks can take.

FIGURE 2.4 HANGING MAN CANDLESTICK

A hanging man candlestick is characterized by a small real body, which can be empty or filled in, and a long

lower shadow.

A hanging man candlestick is characterized by a small real body, which can be empty or illed in, and a long

lower shadow.

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FIGURE 2.5 DAILY CANDLESTICK CHART - S&P 500

This candlestick chart covers the same time period as the charts in Figures 2.1 and 2.2.

Point and Figure Charts

Unlike the charting techniques discussed above, point and figure (P&F) charts ignore timewhen plotting price action. These charts have been around since the late 19 th century and trackthe pure price movement of a security in a compressed format. Only the price changesare plotted,if the price does not change by a certain amount, the chart remains the same (see Figure 2.6).When the interpretation of a bar or candlestick chart is unclear, the P&F chart may give thetechnician a different perspective on which to base a buy or sell decision.

One of the main benefits of point and figure charting is the discovery of intraday support andresistance areas, which may not be as apparent on bar or candlestick charts. As well, it is anexcellent method for discovering when new trends are likely to develop and approximately towhat price level they may reach. Finally, unlike bar or candlestick charts, the P&F chart is veryflexible since it can be designed to be more or less sensitive to price movements.

However, one of the drawbacks of the point and figure chart is that it does not include volume(or in the case of futures contracts, open interest). Also, certain formations apparent on bar andcandlestick charts are not apparent on the point and figure chart.

This candlestick chart covers the same time period as the charts in Figures 2.1 and 2.2.

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Chart Creation

Like a bar chart, a point and figure chart plots price on a vertical scale. However, whereas barcharts plot price in continuous time, P&F charts plot only price (although, in retrospect, datescan be put at the bottom of the chart for reference). As P&F charts are only concerned with pricechanges, the price movement can take place intraday, across three days or across three months,

for example. Remember, the only determining factor is that the price moves enough to justify itsplotting (based on the type of P&F chart being created), otherwise the chart is not updated.

The X records rising prices; the O records declining prices. Each time a trend reverses, a newcolumn is started. The technician has control over sensitivity to trend and trend reversal throughthe choice of the box size and the reversal size.

A box size of $1 is typically used for stocks between $20 and $100. Increasing the box size makesthe P&F chart less sensitive and gives fewer buy/sell signals. If a rally were underway, Xs wouldbe plotted, with a new X being added to the top of the column for each $1 gain. Conversely, ifprices were falling, Os would be plotted, with a new O being added to the bottom of the columnfor each $1 decline.

The reversal size is the number of boxes necessary to reverse a trend (to shift from Xs to Os orfrom Os to Xs). The technician decides how far prices must move against the prevailing trendbefore shifting to a new column and plotting the other symbol. Using a box size of $1, forexample, if a particular stock was trending higher and a 3 box reversal was used, it would takea $3 price decline ($1 $3) to start a new column, which would consist of Os. If a $2 box sizewas used instead, it would take a $6 price decline ($2 $3) to start a new column, and so on. Ifthe equity was trading at $25, the price would need to fall to $22 in order to register a reversal (atrade at $22.15 would not be sufficient).

A P&F chart with a box size of $1 and a reversal size of $3 is known as a 1 3 chart, or 1 x 3reversal chart. If the technician wanted the chart to be more sensitive, a 1 1 chart would beused; if the goal is to take a longer-term view (which eliminates much of the short-term noise), a

1 5 chart could be used.Figures 2.6 and 2.7 show the difference between a 2 5 reversal and a 2 1 reversal chart forIBM (a $2 box size is used since the price is greater than $100). The 2 1 reversal (Figure 2.7)captures most price movements, but only covers nine months of data. The 2 5 reversal (Figure2.6) captures the long-term picture (in this example, 20 years of price action), and leaves outa lot of the noise associated with smaller price movements. Looking at both price scales is animportant part of understanding the big picture. For example, if the 2 1 is flashing a buy signalbut the 2 5 is bearish, a technician may not want to execute a trade or may do so in a muchsmaller amount. When both charts are aligned in the same direction, the resulting signal is muchmore powerful.

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FIGURE 2.6 POINT AND FIGURE CHART (2 X 5) - IBM

Each entry on the chart ( X or O) represents a $2 move in the price of IBM. A new column is started

when the price moves by $10 ($2 5) in the direction opposite the current trend. This chart captures

nearly 20 years of movement in IBMs stock price.

ach entry on the chart ( X or O) represents a $2 move in the price of IBM. A new column is started

when the price moves by $10 $2 5 in the direction opposite the current trend. This chart captures

nearly 20 years of movement in IBMs stock price.

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FIGURE 2.7 POINT AND FIGURE CHART (2 X 1) - IBM

Each entry on this chart represents a $2 move in the price of IBM as well, but a new column is started

when the price moves by $2 ($2 1) in the direction opposite to the current trend. This chart covers a

much smaller time period than the chart in Figure 2.6 since its more sensitive to price changes.

Since P&F charts do not include volume or continuous time, price action is the only elementto be studied. A technician using a P&F chart would look for many of the same formations asthose found on a bar chart. The main difference between price formations on the two methodshas to do with the way in which price projections are determined. Whereas price objectivesare determined by vertical measurements on a bar chart, they are obtained by horizontalmeasurements on a P&F chart (the technician measures the width of the consolidation areaand uses that number of boxes to measure the upside or downside target). P&F formations andmeasuring formulas will be discussed in Chapter 6.

ach entry on this chart represents a $2 move in the price o IBM as well, but a new column is started

when the price moves by $2 ($2 1) in the direction opposite to the current trend. This chart covers a

much smaller time period than the chart in Figure 2.6 since its more sensitive to price changes.

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CHART SCALING

All the charts displayed above use an arithmetic (or linear) scaling. An arithmetic scale showsthe y-axis in equal price units. Therefore, the vertical distance between $1 and $3 is the same

as the distance between $121 and $123, etc. It is a $2 or a 2 point change. On a semi-log (orlogarithmic) scale, however, the y-axis is displayed in equal percentage units. Therefore, thevertical distance between $1 and $3 represents a 200% change in price, the same as a move from$12 to $36.

It should be apparent that a chart can be quite misleading, depending which scaling method isused. This is especially true for securities with large price ranges. Generally, an arithmetic scalecan be used on daily charts since the price fluctuations are relatively small (less than 20%), andmost investors in the shorter-term daily timeframe think of price movements in terms of points.Both scaling methods are available on a wide variety of chart services.

Although arithmetic scaling is widely used, many technicians prefer semi-log. Figures 2.8 and 2.9

show semi-log charts for crude oil futures from 1989 to mid-2008.

FIGURE 2.8 SEMI-LOG PRICE SCALING

Source: BloombergSource: Bloomberg

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FIGURE 2.9 ARITHMETIC PRICE SCALING

Source: Bloomberg

When the arithmetic chart is used (Figure 2.9), higher-priced market action erroneously appearsmore significant, and lower-priced action is compressed. Generally, a semi-log scaling should beused for viewing longer-term charts (2-3 years or more), or charts that have a price range in excessof 20%.

Source: Bloomberg

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CHAPTER SUMMARY

In this chapter, you learned about:

1. The benefits of charting Charts provide a price history as a visual picture, rather than as a list or table of

numbers.

Charts act as a leading indicator by providing an early warning signal that fundamentalchanges may be taking place.

Charts help identify repetitive price patterns and measured moves out of those patterns.

Charts can help determine entry and exit points and their timing.

Charts can help traders be more mechanical and objective (i.e., less emotional) whentrading.

2. How to construct and read bar and line charts

Bar charts can be constructed so that each individual bar can cover any number of timeperiods, from minutes to years.

Bar charts require four pieces of information for each bar: the opening price, the highprice, the low price and the closing price.

Each bar consists of a vertical line with a horizontal line protruding from the left andright side.

The top of the bar represents the high price; the bottom of the bar represents the low

price; the horizontal line to the left of the bar represents the opening price; and thehorizontal line to the right of the bar represents the closing price.

Like bar charts, each plot on a line chart can represent a time period that ranges fromminutes to years.

Line charts require only one piece of price information: the closing price.

Line charts are also known as close-only charts.

3. How to construct and read candlestick charts

Like bar and line charts, candlestick charts can be constructed so that each individualcandlestick covers a wide range of time frames.

Like bar charts, each candlestick requires four pieces of price information: the openingprice, the high price, the low price and the closing price.

Candlesticks have three distinct parts: an upper shadow, a real body and a lowershadow.

The top of the real body represents the opening or closing price, whichever is greater;the bottom of the real body represents the lower of the two.

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When the closing price is lower than the opening price (a down day), the real body isshaded (normally black or red). When the opening price is lower than the closing price(an up day), the real body is unshaded (normally green or white).

The upper shadow extends from the top of the real body to the highest price, whereasthe lower shadow extends from the bottom of the real body to the lowest price.

4. How to construct and read point and figure charts

Unlike the charts discussed earlier, point and figure charts do not plot time on thehorizontal axis; they track only the price movement.

Point and figure charts consist of a series of vertical columns of Xs and Os.

A rising trend is indicated by a column of Xs, and a falling trend is drawn with acolumn of Os.

Each X and O represents a specific dollar amount, called the box size, which is usually$1 for stocks priced between $20 and $100, and $2 for stocks over $100.

A new X is added to the top of a column of Xs when the stock rises by the amount ofthe box size. Similarly, a new O is added to the bottom of a column of Os when thestock falls by the amount of the box size.

A change from a column of Xs to a column of Os (and vice versa) occurs when the priceof the stock moves in the opposite direction to the current trend by an amount equal tothe box size multiplied by the reversal size.

The greater the reversal size, the less sensitive the chart is to choppy, sideways trading.

Endnote

1 Stop-loss orders are used to limit losses on long positions (sell-stop order) or short positions (buy-stop order). The orderbecomes effective only when the price is at, or below, the stop price (in the case of a sell-stop order) or at, or above, thestop price (in the case of a buy-stop order).

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Chapter3

Trend Analysis

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3

Trend Analysis

CHAPTER OUTLINE

Dow Theory

The Averages Discount Everything

The Market has Three Trends

Primary Trends Have Three Phases

The Averages Must Confirm Each Other

Volume Must Confirm the Trend

A Trend Should be Assumed to Persist Until it Gives Definite Signals that it has ReversedSupport and Resistance Levels

Horizontal Support and Resistance

Market Profile

Trendlines

Construction of Trend Channels

Fan Lines

Chapter Summary

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LEARNING OBJECTIVES


Know and explain the six basic tenets of the Dow Theory.1.

Understand support and resistance levels.2.

Identify support and resistance levels by observing a market profile chart.3.

Understand trendlines.4.

KEY TERMS

Accumulation phase On balance volume (OBV)

Confirmation Primary trend

Distribution phase Resistance level

Divergence Secondary trend

Dow Theory Support level

Downtrend Trend channel

Fan lines Trendline

Market Profile chart Uptrend

Minor trend Whipsawed

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DOW THEORY

As discussed in Chapter 1, one of the key assumptions of technical analysis is that markets movein trends and trends tend to persist for relatively long periods of time. Therefore, the key for

the technical analyst is to determine a markets trend, hopefully in its early stages, and to carrypositions until the trend has proven to have reversed.

The oldest and most recognized method of identifying trends evolved from the work of CharlesDow and became known as the Dow Theory.Just as Benjamin Grahams 1934 workSecurityAnalysisis the basis for fundamental analysis, Charles Dow and his theories laid the foundationfor technical analysis. Though modified and adapted, Dows conclusions can still be seen in mostof the principles of modern technical theory.

Charles Dow (1851-1902) was one of the founders of the Dow Jones Company and the firsteditor ofThe Wall Street Journal, first published in July 1889. In 1885 Dow created an index ofthe largest and most liquid representative stocks (mostly railroads). In 1896, he created the

most widely followed market average in the world: the Industrial Average, (exclusively non-railroads), and the original index became the Rail Average. Today they are known as the DowJones Industrial Average and the Dow Jones Transportation Average. It is interesting to note thatDow did not originally design the averages for the purpose of forecasting stock prices. Rather, hisintention was to create a vehicle that used general stock market trends as a barometer for businessconditions.

Through his editorials in The Wall Street Journal, analysts later developed what is now known asthe Dow Theory. Dow himself never wrote this theory, he merely wrote his observations. Otherscompiled it into the cohesive theory that exists to this day.

Dows conclusions were based entirely on his study of closing prices. He focused on the closesince he believed closing prices reflected the price level at which informed investors were willing

to carry their positions overnight. Therefore, in Dows eyes, closing prices most accuratelyreflected investor sentiment. Based on carefully observing closing prices, Dow, and what laterbecame the Dow Theory, advocated six basic tenets:

The Averages discount everything.

The market has three trends.

Primary trends have three phases.

The Averages must confirm each other.

Volume must confirm the trend.

A trend should be assumed to persist until it gives definite signals that it has reversed.

Dows legacy can be seen not only in the worlds most famous and closely watched Dow JonesAverages, but also in the analysis of modern technicians. His careful observations laid thefoundation for twentieth-century technical analysis. Dow Theory can be applied to any marketaverage, and the majority of it can be used to analyze individual securities as well. The six tenetsof Dow Theory have been adapted and incorporated in our understanding of trend identificationand analysis, the principles of divergence and convergence, the importance of volume, and theuse of percentage retracements, to name only a few.

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The Averages Discount Everything

This is one of the most important tenets of Dow Theory. Dows original idea was to quantifyand measure swings in the business cycle. In his research, he came to the conclusion that stockprices reflect both current and future expectations about general business conditions. That is,market participants act on a combination of information and expectation, and the strength in

their buying or selling will reflect their level of confidence. The averages will therefore discount(anticipate) the balance of views.

This part of Dow Theory holds that every factor that can potentially affect the supply anddemand of a stock is reflected in the market averages. Even acts of God (natural disasters),although they cannot be anticipated

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