text TECHNICAL ANALYSIS tar FINANCIAL MARKETS ‘A COMPREHENSIVE GUIDE TO TRADING {ETHODS AND APPLICATIONS TECHNICAL ANALYSIS tie FINANCIAL MARKETS A COMPREHENSIVE GUIDE TO TRADING "METHODS AND APPLICATIONS, JOHN J" MURPHY z is i E bar of Congres Cataloging In Poblicaton ata Map John ate “ia soa fe ancl mathe Jon) "Muy, ele of Tech ans fe aes macht 1986 Fhe bog ence sn ne teu saie" ", 2" "Commodiy exchanges 1 Murphy, Johny eimalpariet i tse mereoat sess" "eons fh ok wee pet pled at ‘eal Aaj of he oe are oh atte of Pit, 98) itd in he Ute States of Amerie ‘Ts pbeaon eget to prove acute and authori information net {othe bert mater cored so wth the nesta at the publ ot (havnt nde pi cemting oe peeing ae OF Seirerstn tn eee eft etn Pre “ren aati of rps ty ac Com of rn “RETENTION, CORTORATIONS AND SCHOOLS oUF teks are amie a guy cots thf pate freon ‘Wheat promsnnal ne For tfomaton ase eo Price al pect SSe""Ter rat Cour Pama, Alone Pane mp ee of tok EN mabe (cat" "how be el be me ead ISON 0-7352-00bL-2 Nw Yor ogTTUT OF FINANCE ems Nae Poorer ar To my parents, Timothy and Margaret and To Patty, Clare, and Brian Contents About the Author xxiii About the Contributors uv Introduction xxvil, Acknowledgments xxx! Philosophy of Technical Analysis Introduction 1 Philosophy or Rationale 2 Technical versus Fundamental Forecasting Analysis versus Timing 6 Contents Flexibility and Adaptability of Technical ‘Analysis 7, ‘Technical Analysis Applied to Different Trading Mediums 8 ‘Technical Analysis Applied to Different Time Dimensions 9) Economie Forecasting 10 Technician or Chartist? 10 A Brief Comparison of Technical Analysis in Stocks and Futures 12 Less Reliance on Market Averages and Indicators 14 Some Criticisms of the Technical Approach 15 Random Walk Theory 19 Universal Principles 21 Dow Theory 23 Introduction 23 Basic Tenets 24 ‘The Use of Closing Prices and the Presence of Lines 30 Some Criticisms of Dow Theory 31 Stocks as Economic Indicators" 32 Dow Theory Applied to Futures Trading 32 Conclusion 33 Contents ix Chart Construction 3S Introduction 35 ‘Types of Charts Available 36 Candlesticks 37 Arithmetic versus Logarithmic Scale 39 Construction of the Daily Bar Chart 40 Volume 47 Futures Open Interest 42 Weekly and Monthly Bar Charts 45 Conclusion 46 Basic Concepts of Trend "49 Definition of Trend 49 ‘Trend Has Three Directions $1 Trend Has Three Classifiations $2 Support and Resistance SS Trendlines 65 ‘The Fan Principle 74 ‘The Importance of the Number Three 76 ‘The Relative Steepness of the Trendline 76 ‘The Channel Line 80 Percentage Retracements 85 conten Speed Resistance Lines 87 Gann and Fibonacci Fan Lines 90 Internal Trendlines 90 Reversal Days 90 Price Gaps 94 Conclusion 98 Major Reversal Patterns 99 Introduction — 99 Price Patterns 100 ‘Two Types of Patterns: Reversal and Continuation 100 ‘The Head and Shoulders Reversal Pattern 103 ‘The Importance of Volume 107 Finding a Price Objective 108 ‘The Inverse Head and Shoulders 110 Complex Head and Shoulders 113 ‘Thiple Tops and Bottoms 115 Double Tops and Bottoms 117 Variations from the Ideal Pattern 121 Saucers and Spikes 125 Conclusion 128 contents xi Continuation Patterns 129 Introduction 129 ‘Twiangles 130 ‘The Symmetrical Triangle 132 The Ascending Triangle 136 The Descending Tangle 138 ‘The Broadening Formation 140 Flags and Pennants 141 ‘The Wedge Formation 146 ‘The Rectangle Formation 147, ‘The Measured Move 151 ‘The Continuation Head and Shoulders Pattern 153 Confirmation and Divergence 155 Conclusion 156 Volume and Open Interest 157 Inoduction 157 Volume and Open Interest as Secondary Indicators 158 Interpretation of Volume for All Markets 162 Interpretation of Open Interest in Futures 169 Summary of Volume and Open Interest Rules Blowotfs and Selling Climaxes 175 Commitments of Traders Report 175 Watch the Commercials 176 Net Trader Positions 177 Open Interest In Options 177 Put/Call Ratios" "178 ‘Combine Option Sentiment With Technicals Conclusion 179 Long Term Charts Introduction 181 ‘The Importance of Longer Range Perspective Construction of Continuation Charts for Futures ‘The Perpetual Contract™ 184 Long Term Trends Dispute Randomness 184 Patterns on Charts: Weekly and Monthly Reversals 185 Long Term to Short Term Charts 185 ‘Why Should Long Range Charts Be Adjusted for Inflation? 186 Long Term Charts Not Intended for Trading, Purposes 188 Examples of Long Term Charts 188 179 182 181 182 Contents xiii Moving Averages Introduction 195 ‘The Moving Average: A Smoothing Device with a Time Lag 197 Moving Average Envelopes 207 Bollinger Bands 209 Using Bollinger Bands as Targets" 210 Band Width Measures Volatility 211 Moving Averages Tied to Cycles 212 Fibonacci Numbers Used as Moving Averages 212 Moving Averages Applied to Long Term Charts 213 ‘The Weekly Rule 215 ‘To Optimize or Not 220 Summary 221 The Adaptive Moving Average 222 Alternatives to the Moving Average 223 Oscillators and Contrary Opinion Introduction 225 ‘Oscillator Usage in Conjunction with Trend 226 Measuring Momentum 228 195 225 xiv Measuring Rate of Change (ROC) 234 Constructing an Oscillator Using Two Moving Averages 234 ‘Commodity Channel Index 237 ‘The Relative Strength Index (RSI) 239 Using the 70 and 30 Lines to Generate Signals 245 ‘Stochastics (K%D) 246 Larry Williams %R 249 ‘The Importance of Trend 251 When Oscillators are Most Useful 251 Moving Average Convergence/Divergence (MACD) 252 MACD Histogram 25 Combine Weeklies and Dailies 256 The Principle of Contrary Opinion in Futures 257 Investor Sentiment Readings 261 Investors Intelligence Numbers 262 Point and Figure Charting 265 Introduction 266 ‘The Point and Figure Versus the Bar Chart 270 Construction of the Intraday Point and Figure Chart 270 ‘The Horizontal Count 274 Price Patterns 275 ‘Measuring Rate of Change (ROC) 234 Constructing an Oscillator Using Two Moving Averages 234 ‘Commodity Channel Index 237 ‘The Relative Strength Index (RSI) 239 Using the 70 and 30 Lines to Generate Signals Stochastics (K%D) 246 Larry Williams %R 249 ‘The Importance of Trend 251 When Oscillators are Most Useful 251 Moving Average Convergence/Divergenice (MACD) 252 MACD Histogram 255 Combine Weeklies and Dailies 256 ‘The Principle of Contrary Opinion in Futures Investor Sentiment Readings 261 Investors Intelligence Numbers 262 Point and Figure Charting Introduction 266 ‘The Point and Figure Versus the Bar Chart Construction of the Intraday Point and Figure Chart 270 ‘The Horizontal Count 274 Price Patterns 275 24s 287 270 265 xiv Contents Measuring Rate of Change (ROC) 234 Constructing an Oscillator Using Two Moving ‘Averages 234 ‘Commodity Channel Index 237 ‘The Relative Strength Index (RS) 239 Using the 70 and 30 Lines to Generate Signals Stochastics (K%D) 246 Larry Williams %R 249 ‘The Importance of Trend 251 When Oscillators are Most Useful 251 Moving Average Convergence/Divergence (MACD) 252 MACD Histogram 255 Combine Weeklies and Dailies 256 ‘The Principle of Contrary Opinion in Futures Investor Sentiment Readings 261 Investors Intelligence Numbers 262 Point and Figure Chartin; Introduction 266 ‘The Point and Figure Versus the Bar Chart Construction of the Intraday Point and Figure Chart 270 The Horizontal Count 274 Price Patterns 275 245 287 265 270 Concerts av 3 Box Reversal Point and Figure Charting 277 Construction of the 3 Point Reversal Chart 278 ‘The Drawing of Trendlines 282 Measuring Techniques 286 ‘Trading Tactics 286 Advantages of Point and Figure Charts 288 PRE Technical Indicators 292 Computerized PSF Charting 292 P&F Moving Averages 294 Conclusion 296 * Japanese Candlesticks 297 Introduction 297 Candlestick Charting 297 Basic Candlesticks 299 Candle Pattern Analysis 301 Filtered Candle Patterns 306 Conclusion 308 Candle Patterns 309 Elliott Wave Theory 319 Historical Background 319 ‘The Basic Tenets of the Elliott Wave Principle 320 xvi ‘Connection Between Elliott Wave and Dow ‘Theory 324 Corrective Waves 324 ‘The Rule of Alternation 331 Channeling 332 Wave 4 as a Support Area 334 Fibonacci Numbers as the Basis of the Wave Principle 334 ‘ibonacci Ratios and Retracements 335 Fibonacci Time Targets "338 ‘Combining All Three Aspects of Wave Theory Elliott Wave Applied to Stocks Versus Commodities 340 Summary and Conclusions 347 Reference Material 342 Time Cycles Introduction 343 Cycles 344 How Cyclic Concepts Help Explain Charting Techniques 355 Dominant Cycles 358 Combining Cycle Lengths 361 ‘The Importance of Trend 361 Left and Right Translation 362 How to Isolate Cycles, 363 338 343 Contents xvii Seasonal Cycles 369 Stock Market Cycles 373 ‘The January Barometer 373 ‘The Presidential Cycle 373 Combining Cycles with Other Technical Tools 374 ‘Maximum Entropy Spectral Analysis 374 Cycle Reading and Software 375 Computers and Trading Systems 377 Introduction 377 Some Computer Needs 379 Grouping Tools and Indicators 380 Using the Tools and Indicators 380 Welles Wilder's Parabolic and Directional Movement Systems 381 Pros and Cons of System Trading 387 Need Expert Help? 389 ‘Test Systems or Create Your Own 390 Conclusion 390 Money Management and Trading Tactics 393 Introduction 393 The Three Elements of Successful Trading 393 xviib Money Management 394 Reward to Risk Ratios 397 ‘Trading Multiple Positions: Trending versus Trading Units 398 ‘What to Do After Periods of Success and Adversity 399 ‘Trading Tactics 400 Combining Technical Factors and Money Management 403, ‘Types of Trading Orders 403, From Daily Charts to Intraday Price Charts 405 The Use of Intraday Pivot Points 407 ‘Summary of Money Management and Trading Guidelines 408 Application to Stocks 409 Asset Allocation 409 Managed Accounts and Mutual Funds 410 Market Profile 411 ‘The Link Between Stocks and Futures: Intermarket Analysis Intermarket Analysis 414 Program ‘Trading: The Ultimate Link 415 ‘The Link Between Bonds and Stocks 416 ‘The Link Between Bonds and Commodities 418 ‘The Link Between Commodities and the Dollar 413 Contents xix Stock Sectors and Industry Groups 420 ‘The Dollar and Large Caps 422 Intermarket Analysis and Mutual Funds 422 Relative Strength Analysis 423 Relative Strength and Sectors" "424 Relative Strength and Individual Stocks 426 Top-Down Market Approach 427 Deflation Scenario 427 Intermarket Correlation 428 Intermarket Neural Network Software 429 Conclusion 430 \ Stock Market Indicators 433 Measuring Market Breadth 433, Sample Data 434 ‘Comparing Market Averages 435 The Advance-Decline Line 436 AD Divergence 437 Daily Versus Weekly AD Lines 437 Variations in AD Line 437 McClellan Oscillator 438 McClellan Summation Index 439 New Highs Versus New Lows 440" New High-New Low Index 441 Upside Versus Downside Volume 443 ‘The Arms Index 444 TRIN Versus TICK 444 ‘Smoothing the Arms Index 445 Open Arms 446 Equivolume Charting 447 Candlepower 448 ‘Comparing Market Averages 449 Conclusion 452 x Pulling It All Together—A Checklist ‘Technical Checklist 454 How to Coordinate Technical and Fundamental Analysis 455 Chartered Market Technician (CMT) 456 Market Technicians Association (MTA) 457 ‘The Global Reach of Technical Analysis 458 ‘Technical Analysis by Any Name 458 Federal Reserve Finally Approves 459 Conclusion 460 Advanced Technical Indicators Demand Index (DI) 463 Herrick Payoff Index (HP) 466 483 463 contents Stare Bands and Keltner Channels 469 Formula for Demand Index 473 Market Profile Introduction 475 Market Profile Graphic 478 Market Structure 479) Market Profile Organizing Principles 480 "Range Development and Profile Patterns 484 ‘Tracking Longer Term Market Activity 486 Conclusion 490 ‘The Essentials of Building a Trading System SStep Plan 494 Step 1: Start with a Concept (an Idea) 495 Step 2: Turn Your Idea into a Set of Objective Rules 497 Step 3: Visually Check It Out on the Charts 497 Step 4: Step Money Management S01 Conclusion $01 ‘ormally Test It with a Computer 497, valuate Results $00 475 493 wall Contents < Continuous Futures Contracts $05 Nearest Contract 506 Next Contract 506 Gann Contract 507, Continuous Contracts $07 Constant Forward Continuous Contracts" "$08 Glossary S11 Selected Bibliography 523, Selected Resources 527 Index 531 About the Author REG Ns" John J Murphy has been applying technical analysis for three ‘decades "He was formerly Director of Futures Technical Research, and the senior managed account trading advisor with Merrill Lynch" Mr Murphy was the technical analyst for CNBC-TV for seven years "He is the author of three books, including Technical Analysis of the Futures Markets, the predecessor to this book" "His second book, Intermarket Technical Analysis, opened up a new branch of analysis" "His third book, The Visual Investor, applies technical work to mutual funds, In 1996, Mz" "Murphy founded MURPHYMORRIS, Inc" ", along with software developer Greg Mortis, to produce interactive ‘educational products and online analysis for investors" Their Web site address is: ‘eww murphymorris com "He is also head of his own consulting firm, JJM ‘Technical Advisors, located in Oradell, New Jersey" vod About the Contributors ‘Thomas E Aspray (Appendix A) is a Capital Market Analyst with Princeton Economic Institute Ltd ", located in Princeton, New Jersey" "Mr, Aspray has been trading markets since the 1970s" Many 6f the techniques he pioneered in the early 1980s are now used by other professional traders ‘Dennis C Hynes (Appendix B) is Managing Director and cofounder of RW Pressprich & Co ", Inc,, a fixed income bro- ker/dealer located in New York City" He also serves as the firm's ‘Chief Market Strategist Mr Hynes is a futures and options trader and a CTA (Commodity Trading Advisor) He has an MBA in Finance from the University of Houston ‘Greg Morris (Chapter 12 and Appendix D) has been devel- ping trading systems and indicators for 20 years for investors and traders to be used with major technical analysts software pro- ‘grams He is the author of two books on candlestick charting (see ‘Chapter 12) "In August 1996, Mr" Morris teamed with John Murphy to found MURPHYMORRIS Inc ", a Dallas-based firm ded- cated to educating investor ay awl About the Contributors Fred G, Schutzman, CMT (Appendix C) is the President and Chief Executive Officer of Briarwood Capital Management, Inc,, a New York-based Commodity Trading Advisor" "He is also responsible for technical research and trading system develop- ‘ment at Emcor Eurocurrency Management Corporation, a risk ‘management consulting firm" Mr Schuteman is member of the ‘Market Technicians Association and is currently serving on their Board of Directors Thad no idea when Technical Analysis of the Futures Markets was published in 1986 that it would create such an impact on the Industry It has been referred to by many in the field as the “Bible” Cf technical analysis The Market Technicians Association uses it a a primary source in their testing process for the Chartered ‘Market Technician program The Federal Reserve has cited it in research studies that examine the value of the technical approach "In addition, it has been translated into eight foreign languages" | ‘was also unprepared for the long shelf life of the book It contin- tes to sell as many coples ten years after it was published as it did in the first couple of years "It became clear, however, that a lot of new material had ‘been added to the field of technical analysis in the past decade" I added some of it myself "My second book, Intermarket Technical ‘Analysis (Wiley, 1991), helped create that new branch of technical analysis, which is widely used today" Old techniques like Japanese candlestick charting and newer ones like Market Profile have become part of the technical landscape "Clearly, this new work xxvii avi Inesducton needed to be included in any book that attempted to present a ‘comprehensive picture of technical analysis" "The focus of my work changed as well, While my main interest ten years ago was in the futures ‘markets, my recent work has dealt more with the stock market" "‘That also brought me full citce, since I began my career as a stock analyst thirty years ago" That was also one of the side effects of my being the technical analyst for CNBC-TV for seven years "That focus on what the general public was doing also led to my third bbook, The Visual Investor (Wiley, 1996)" "That book focused on the use of technical tools for market sectors, primarily through mutu- al funds, which have become extremely popular in the 1990s, ‘Many of the technical indicators that 1 wrote about ten ‘years ago, which had been used primarily in the futures markets, have been incorporated into stock market work" It was time to show how that was being done "Finally, lke any field or disci pline, writers also evolve" Some things that seemed very impor- {ant to me ten years ago aren't as important today "As my work hhas evolved into a broader application of technical principles to all financial markets, it seemed only right that any revision of that earlier work should reflect that evolution" I've tried to retain the structure of the original book "‘Therefore, many of the original chapters remain" "However, they have been revised with new material and updated with new graphics" Since the principles of technical analysis are univers wasn't that difficult to broaden the focus to include all financial ‘markets "Since the original focus was on futures, however, a lot of stock market material has been added" ‘Three new chapters have been added The two previous chapters on point and figure charting (Chapters 11 and 12) have been merged into one A new Chapter 12 on candlestick charting has been inserted Two additional chapters have also been added at the end of the book Chapter 17 is an introduction to my work ‘on intermarket analysis Chapter 18 deals with stock market in« ‘ators We've replaced the previous appendices with new ones "“Market Profile is introduced in Appendix B, The other appendices show some of the more advanced technical indicators and explain how to build a technical trading system" There's also a glossary Imreducten xxix | approached this revision with some trepidation I wasn’t sure redoing a book considered a “classic” was such a good idea I hhope I've succeeded in making it even better | approached this ‘work from the perspective of a more seasoned and mature writer and analyst "And, throughout the book, I tried to show the respect have always had for the discipline of technical analysis and for the many talented analysts who practice it" "The success of their work, as well as their dedication to this field, has always been a source of comfort and inspiration to me" "| only hope I did justice tot and to them, John Murphy Acknowledgments ‘The person who deserves the most credit for the second edition of this book is Ellen Schneid Coleman, Executive Editor at Simon & Schuster" She convinced me that it was time to revise Téchnical ‘Analysis of the Futures Markets and broaden its scope I'm glad she ‘was So persistent "Special thanks go to the folks at Omega Research who provided me with the charting software I needed and, in par- ticular, Gaston Sanchez who spent a lot of time on the phone with me" "The contributing authors—Tom Aspray, Dennis Hynes, and Fred Schutzman—added their particular expertise where it was needed" "In addition, several analysts contributed charts including ‘Michael Burke, Stan Ehrlich, Jerry Toepke, Ken Tower, and Nick Van Nice" The revision of Chapter 2 "0n Dow Theory was a collab- orative effort with Elyce Picciott an independent technical writer and market consultant in New Orleans, Louisiana, Greg Mortis deserves special mention" "He wrote the chapter on candlestick charting, contributed the article in Appendix D, and did most of the graphic work" "Fred Dahl of Inkwell Publishing Services (Fishkill, NY), who handled production of the first edition of this book, did this one as wel" It was great working with him again "xxxi TECHNICAL ANALYSIS St FINANCIAL MARKETS _ ‘A COMPREHENSIVE GUIDE TO TRADING ‘METHODS AND APPLICATIONS Philosophy of Technical Analysis INTRODUCTION Before beginning a study of the actual techniques and tools used Jn technical analysis, it is necessary first to define what technical analysis is, to discuss the philosophical premises on which it is based, to draw some clear distinctions between technical and fun- damental analysis and, finally, to address a couple of criticisms fre- ‘quently raised against the technical approach" "“The author's strong belief is that a full appreciation of the technical approach must begin with clear understanding of what technical analysis claims to be able to do and, maybe even ‘more importantly, the philosophy or rationale on which it bases those claims" "Furst, le’s define the subject" "Technical analysis isthe study ‘of market action, primarily through the use of charts, for the purpose of forecasting future price trends" "The term ‘market action” includes the three principal sources of information available to the techni- 2 Chapter 1 ian—price, volume, and open interest" (Open interest is used conly in futures and options ") The term “price action,” which is often used, seems too narrow because most technicians include volume and open interest as an integral part of their market analysis, With this distinction made, the terms *price action” and, “market action” are used interchangeably throughout the remain- er of this discussion" "PHILOSOPHY OR RATIONALE ‘There are three premises on which the technical approach is, based: 1, Market action discounts everything, 2, Prices move in trends 43" History repeats itself Market Action Discounts Everything ‘The statement “market action discounts everything” forms what is probably the comerstone of technical analysis "Unless the full significance of this first premise s fully understood and accepted, nothing else that follows makes much sense" "The technician believes that anything that can possibly affect the price—funda- mentally, politically, psychologically, or otherwise—is actually reflected in the price of that market" "It follows, therefore, that 2 study of price action is all that is required" "While this claim may ‘seem presumptuous, it is hard to disagree with if one takes the ‘time to consider its true meaning All the technician is really claiming is that price action should reflect shifts in supply and demand" "If demand exceeds supply, prices should rise" "If supply exceeds demand, prices should fall" This action is the basis of all economic and funds- ‘mental forecasting "The technician then turns this statement around to arrive at the conclusion that if prices are rising, for ‘whatever the specific reasons, demand must exceed supply and the fundamentals must be bullish" "If prices fall, the fundamen- Phicsopy of Tecnica Antss 3 tals must be bearish" "If this last comment about fundamentals seems surprising in the context of a discussion of technical analysis, it shouldn't" "After all, the technician is indirectly studying fundamentals" "Most technicians would probably agree that It is the underlying forces of supply and demand, the eco- nomic fundamentals of a market, that cause bull and bear mar- kets" The charts do not in themselves cause markets to move up or down They simply reflect the bullish or bearish psychology of the marketplace "Asa rule, chartists do not concern themselves with the rea- sons why prices rise or fall, Very often, in the early stages of a price trend or at critical turning points, no one seems to know exactly why a market is performing a certain way" "While the tech- nical approach may sometimes seem overly simplistic in its Claims, the logic behind this first premise—that markets discount everything—becomes more compelling the more market experi- ‘ence one gains" "It follows then that if everything that affects mar- ket price is ultimately reflected in market price, then the study of that market price is all that is necessary" "By studying price charts and a host of supporting technical indicators, the chartist in effect, lets the market tell him or her which way it is most likely to go" ‘The chartist does not necessarily try to outsmart or outguess the ‘market "All of the technical tools discussed later on are simply techniques used to aid the chartist in the process of studying mar- ket action, The chartist knows there are reasons why markets go up or down" He or she just doesn’t believe that knowing what those reasons are is necessary in the forecasting process Prices Move in Trends ‘The concept of trend Is absolutely essential to the technical approach "Here again, unless one accepts the premise that markets do in fact trend, there's no point in reading any further" The ‘whole purpose of charting the price action of a market is to iden- tify trends in early stages of their development for the purpose of trading in the direction of those trends "In fact, most of the tech- niques used in this approach are trend-following in nature, mean ing that their intent is to identify and follow existing trends" (See Figure 1 1) Figure 1 1 Example ofan uptrend Technical analysis s based on the ‘premise that markets trend and that those trends tend to persis "‘There is a corollary to the premise that prices move in trends—a trend in motion is more likely to continue than to reverse This corollary is, of course, an adaptation of Newton's frst law of| motion" Another way to state this corollary is that a trend in ‘motion will continue in the same direction until it reverses "This is another one of those technical claims that seems almost circu- lar, But the entire trend-following approach Is predicated on rid- ing an existing trend until it shows signs of reversing" History Repeats Itself ‘Much of the body of technical analysis and the study of market action has to do with the study of human psychology "Chart pat- terns, for example, which have been identified and categorized over the past one hundred years, reflect certain pictures that appear on price charts" "These pictures reveal the bullish or bearish Phicsophy of Technical Anas 5 psychology of the market, Since these patterns have worked well in the past, itis assumed that they will continue to work well in the future, They are based on the study of human psychology, which tends not to change" "Another way of saying this last premise—that history repeats itself—is that the key to under- standing the future lies ina study of the past, or that the future is just a repetition of the past" "‘TECHNICAL VERSUS: FUNDAMENTAL FORECASTING ‘While technical analysis concentrates on the study of market action, fundamental analysis focuses on the economic forces of supply and demand that cause prices to move higher, lower, or stay the same" The fundamental approach examines all of the rel- evant factors affecting the price of a market in order to determine the intrinsic value of that market The intrinsic value is what the fundamentals indicate something is actually worth based on the law of supply and demand "If this intrinsic value is under the cur- rent market price, then the market is overpriced and should be sold" "If market price is below the intrinsic value, then the market {s undervalued and should be bought" "Both of these approaches to market forecasting attempt to solve the same problem, that is, to determine the direction prices are likely to move" They just approach the problem from different directions "The fundamentalist studies the cause of market movement, while the technician studies the effec" "The technician, of course, believes that the effect is all that he or she wants or needs to know and that the reasons, of the causes, are unnecessary" The funda- ‘mentalist always has to know why Most traders classify themselves as either technicians ot fundamentalists "In reality, there isa lot of overlap" "Many funda- mentalists have a working knowledge of the basic tenets of chart analysis, At the same time, many technicians have at least a pass- Ing awareness of the fundamentals" The problem is that the charts and fundamentals are often in conflict with each other "Usually at the beginning of important market moves, the fundamentals do not explain or support what the market seems to be doing" "It is at these critical times in the trend that these two approaches seem to differ the most, Usually they come back into syne at some point, but often too late for the trader to act" ‘One explanation for these seeming discrepancies is that ‘market price tends to lead the known fundamentals "Stated another way, market price acts asa leading indicator of the fundamentals or the conventional wisdom of the moment" "While the known funda- ‘mentals have already been discounted and are already “in the mar- ket,” prices are now reacting to the unknown fundamentals" "Some Of the most dramatic bull and bear markets in history have begun with little or no perceived change in the fundamentals, By the time those changes became known, the new trend was well underway" "‘After a while, the technician develops increased confidence In his or her ability to read the charts" The technician learns to be comfortable in a situation where market movement disagrees with the so-called conventional wisdom A technician begins to enjoy being in the minority He or she knows that eventually the reasons for market action will become common knowledge itis just that the technician isn’t willing to wait for that added confirmation "In accepting the premises of technical analysis, one can see why technicians believe their approach is superior to the funda- mentalists" "If a trader had to choose only one of the two approaches to use, the choice would logically have to be the tech- nical" "Because, by definition, the technical approach includes the fundamental" "If the fundamentals are reflected in market price, then the study of those fundamentals becomes unnecessary" Chart reading becomes a shortcut form of fundamental analysis "The reverse, however, is not true, Fundamental analysis does not include a study of price action" It is possible to trade financial ‘markets using just the technical approach "It is doubtful that any- fone could trade off the fundamentals alone with no consideration Of the technical side of the market, ANALYSIS VERSUS TIMING ‘This last point is made clearer if the decision making process is broken down into two separate stages—analysis and timing, Phicsophy Teco Arabs 7 Because of the high leverage factor in the futures markets, timing js especially crucial in that arena" It is quite possible to be correct fon the general trend of the market and still lose money "Because ‘margin requirements are so low in futures trading (usually less than 10%), a relatively small price move in the wrong direction ccan force the trader out of the market with the resulting loss of all ‘or most of that margin" "In stock market trading, by contrast, a trader who finds him or herself on the wrong side of the market ‘can simply decide to hold onto the stock, hoping that it will stage ‘a comeback at some point" Futures traders don’t have that luxury A “buy and hold” strategy doesn’t apply to the futures arena Both the technical and the fundamental approach can be used in the first phase—the forecasting process "However, the question of timing, of deter- ‘mining specific entry and exit points, is almost purely technical Therefore, considering the steps the trader must go through befor making a market commitment, it can be seen that the correct application of technical principles becomes indispensable at some ppoint in the process, even if fundamental analysis was applied in ‘te earlier stages of the decision" Timing is also important in indl- vvidual stock selection and in the buying and selling of stock mar- ket sector and industry groups FLEXIBILITY AND ADAPTABILITY OF TECHNICAL ANALYSIS One of the great strengths of technical analysis is its adaptability to virtually any trading medium and time dimension There is no area of trading in either stocks or futures where these principles do not apply "‘The chartist can easily follow as many markets as desired, ‘which is generally not true of his or her fundamental counterpart" "Because of the tremendous amount of data the latter must deal ‘with, most fundamentalists tend to specialize" The advantages here should not be overlooked "For one thing, markets go through active and dormant periods, trending and nontrending stages, The technician can" & Chapter} concentrate his or her attention and resources in those markets that display strong trending tendencies and choose to ignore the rest "AS a result, the chartist can rotate his or her attention and capital to take advantage of the rotational nature of the markets, At different times, certain markets become “hot” and experience important trends" "Usually, those trending periods are followed by quiet and relatively trendless market conditions, while another market or group takes over" The technical trader is free to pick and ‘choose "The fundamentalist, however, who tends to specialize in only one group, doesn’t have that kind of flexibility, Even if he or she were free to switch groups, the fundamentalist would have a ‘much more difficult time doing so than would the chartist" ‘Another advantage the technician has is the “big picture "” By following all of the markets, he or she gets an excellent feel for What markets are doing in general, and avoids the “tunnel vision” that can result from following only one group of markets" "Also, because so many of the markets have built-in economic relation: ships and react to similar economic factors, price action in one ‘market or group may give valuable clues to the future direction of another market or group of markets" TECHNICAL ANALYSIS APPLIED TO DIFFERENT TRADING MEDIUMS ‘The principles of chart analysis apply to both stocks and futures "Actually, technical analysis was first applied to the stock market land later adapted to futures" "With the introduction of stock index futures, the dividing line between these two areas is rapidly disap- eating" International stock markets are also charted and analyzed according to technical principles (See Figure 1 2 ") Financial futures, including interest rate markets and foreign ‘currencies, have become enormously popular over the past decade and have proven to be excellent subjects for chart analysis" Technical principles play a role in options trading Technical forecasting can also be used to great advantage in the hedging process eed Figure 1 2 The Japanese stack market chars very wll as do most tock ‘markets around the world ‘TECHNICAL ANALYSIS APPLIED TO DIFFERENT TIME DIMENSIONS ‘Another strength of the charting approach is its ability to handle ‘er progresses through the various sections of this book" ‘There may even be hope for the academic world A num- ber of leading American universities have begun to explore Behavioral Finance which maintains that human psychology and securities pricing are intertwined "That, of course, is the primary basis of technical analysis" "UNIVERSAL PRINCIPLES ‘When an earlier version of this book was published twelve years ago, many of the technical timing tools that were explained were ‘used mainly in the futures markets" "Over the past decade, howev- 22 chapter? er, these tools have been widely employed in analyzing stock mat kket trends" "The technical principles that are discussed in this book ‘can be applied universally to all markets—even mutual funds ‘One additional feature of stock market trading that has gained ‘wide popularity in the past decade has been sector investing, pel- marily through index options and mutual funds" Later in the book we'll show how to determine which sectors are hot and ‘which are not by applying technical timing tools "INTRODUCTION ‘Charles Dow and his partner Edward Jones founded Dow Jones & Company in 1882, Most technicians and students of the markets concur that much of what we call technical analysis today has its Origins in theories first proposed by Dow around the turn of the ‘century" Dow published his ideas ina series of editorials he wrote for the Wall Stret Journal "Most technicians today recognize and assimilate Dow's basic ideas, whether or not they recognize the Source" "Dow Theory still forms the comerstone of the study of technical analysis, even in the face of today's sophisticated com- pputer technology, and the proliferation of newer and supposedly better technical indicators" "‘On July 3, 1884, Dow published the first stock market aver age composed of the closing prices of eleven stocks: nine railroad Companies and two manufacturing firms" Dow felt that these ‘leven stocks provided a good indication of the economic health fof the country "In 1897, Dow determined that two separate indices would better represent that health, and created a 12 stock {industrial index and a 20 stock rail index" "By 1928 the industrial 23 24 Chopter2 index had grown to include 30 stocks, the number at which It stands today" "The editors of The Wall Stret Joumal have updated the list numerous times in the ensuing years, adding a utility index in 1929" "In 1984, the year that marked the one hundredth" "anniversary of Dow's first publication, the Market Technicians ‘Association presented a Gorham-silver bowl to Dow Jones & Co" "‘According to the MTA, the award recognized “the lasting contri- ution that Charles Dow made to the field of investment analy- sis" "His index, the forerunner of what today is regarded as the Teading barometer of stock market activity, remains a vital tool for ‘market technicians 80 years after hs death" "” Unfortunately for us, Dow never wrote a book on his the: ‘ory" "Instead, he set down his ideas of stock market behavior in a seties of editorials that The Wall Stret Jounal published around the turn of the century" "In 1903, the year after Dow’s death, S" A ‘Nelson compiled these essays into a book entitled The ABC of ‘Stock Speculation "In that work, Nelson first coined the term “Dow's Theory" "” Richard Russell, who wrote the introduction to a 1978 reprint, compared Dow's contribution to stock market theo- ry with Freud's contribution to psychiatry, In 1922, William Peter Hamilton (Dow's associate and successor at the Journal) catego- ‘ized and published Dow's tenets in a book entitled The Stock ‘Market Barometer" "Robert Rhea developed the theory even further in the Dow Theory (New York: Barron’s), published in 1932" Dow applied his theoretical work to the stock market aver- ‘ages that he created; namely the Industrials and the Rails "However, most of his analytical ideas apply equally well to all market averages" This chapter will describe the six basic tenets of Dow Theory and will discuss how these ideas fit into a modern study of technical analysis We will discuss the ramifications of these ideas in the chapters that follow BASIC TENETS 1 The Averages Discount Everything "The sum and tendency of the transactions of the Stock [Exchange represent the sum of all Wall Sue's know! ow Theory 2s ‘edge of the past, immediate and remote, applied to the fiscounting of the future, There is no need to add to the averages, a5 some statisticians do, elaborate compilations ‘of commodity price index numbers, Bank clearings, fuc- tuations in exchange, volume of domestic and foreign trades or anything else, Wall Steet considers all these things (Hamilton, pp" "40-41) Sound familiar? The idea that the markets reflect every possible knowable factor that affects overall supply and demand {s one of the basic premises of technical theory, as was mentioned in Chapter 1" "The theory applies to market averages, as well as it does to individual markets, and even makes allowances for “acts ‘of God" "” While the markets cannot anticipate events such as earthquakes and various other natural calamities, they quickly discount such occurrences, and almost instantaneously assimilate their affects into the price action, 2" The Market Has Three Trends "Before discussing how trends behave, we must clarify what Dow considered a trend, Dow defined an uptrend asa situation in which ‘each successive rally closes higher than the previous rally high, and" ‘each successive rally low also closes higher than the previous rally low "In other words, an uptrend has a pattern of rising peaks and" troughs "The opposite situation, with successively lower peaks and troughs, defines a downtrend" Dow's definition has withstood the test of time and still forms the cornerstone of trend analysis Dow believed that the laws of action and reaction apply to the markets just as they do to the physical universe "He wrote, “Records of trading show that in many cases when a stock reach- es top it will have a moderate decline and then go back again to near the highest figures" "If after such a move, the price again recedes, it is lable to decline some distance” (Nelson, page 43)" "‘Dow considered a trend to have three parts, primary, sec ‘ondary, and minor, which he compared to the tide, waves, and rip- ples of the sea, The primary trend represents the tide, the sec- ‘Ondary or intermediate trend represents the waves that make up the tide, and the minor trends behave like ripples on the waves" ‘An observer can determine the direction of the tide by not- ing the highest point on the beach reached by successive waves "If each successive wave reaches further inland than the preceding ‘one, the tide is lowing in" "When the high point of each succes- sive wave recedes, the tide has turned out and is ebbing" "Unlike actual ocean tides, which last a matter of hours, Dow conceived fof market tides as lasting for more than a year, and possibly for several years" "‘The secondary, or intermediate, trend represents correc- tions in the primary trend and usually lasts three weeks to three ‘months" "These intermediate corrections generally retrace between one-third and two-thirds of the previous trend movement and ‘most frequently about half, or 50%, of the previous move" "‘According to Dow, the minor (or near term) trend usually lasts less than three weeks, This near term trend represents fluc- tuations In the intermediate trend, We will discuss trend concepts in greater detail in Chapter 4, “Basic Concepts of Trends,” where {you will see that we continue to use the same basic concepts and terminology today" 3 Major Trends Have Three Phases "Dow focused his attention on primary or major trends, which he felt usually take place in three distinct phases: an accumulation pphase, a public participation phase, and a distribution phase" The ‘accumulation phase represents informed buying by the most astute investors "If the previous trend was down, then at this ppolnt these astute investors recognize that the market has assimi- lated all the so-called ""bad"" news" "The public participation phase, ‘where most technical trend-followers begin to participate, occurs when prices begin to advance rapidly and business news improves" The distribution phase takes place when newspapers ‘begin to print increasingly bullish stories; when economic news is better than ever; and when speculative volume and public partic- ipation increase "During this last phase the same informed investors who began to “accumulate” near the bear market bot tom (when no one else wanted to buy) begin to “distribute” before anyone else starts selling, ow Theory 27 Students of Elliott Wave Theory will recognize this divi sion of a major bull market into three distinct phases" R N "Elliott elaborated upon Rhea’s work in Dow Theory, to recognize that a bull market has three major, upward movements" "In Chapter 13, “Elliott Wave Theory,” we'll show the close similari- ty between Dow's three phases of a bull market and the five wave Elliott sequence" 4 The Averages Must Confirm Each Other "Dow, in referring to the Industrial and Rail Averages, meant that ‘no important bull or bear market signal could take place unless both averages gave the same signal, thus confirming each other" He felt that both averages must exceed a previous secondary peak to confirm the inception or continuation of a bull market "He did not believe that the signals had to occur simultaneously, but rec: ‘ognized that a shorter length of time between the two signals pro- vvided stronger confirmation, When the two averages diverged from one another, Dow assumed that the prior trend was still maintained, (Elliott Wave Theory only requites that signals be generated in a single average" ") Chapter 6, “Continuation Patterns,” will cover the key concepts of confirmation and diver- gence" (See Figures 2 1 and 2 2 ) 5 Volume Must Confirm the Trend Dow recognized volume as a secondary but important factor in confirming price signals "Simply stated, volume should expand or increase in the direction of the major trend" In "a major uptrend, vol- lume would then increase as prices move higher, and diminish as prices fall, In a downtrend, volume should increase as prices drop and diminish as they rally" "Dow considered volume a secondary Indicator, He based his actual buy and sell signals entirely on clos- ing prices" "In Chapter 7, “Volume and Open Interest,” we'll cover the Subject of volume and bulld on Dow's ideas" Today's sophisti- cated volume indicators help determine whether volume is Increasing or falling off Savvy traders then compare this infor- ‘mation to price action to see if the two are confirming each other 2B Copter? Figure 2 1 "A long toon view of the Dow Theory at work Fora major bull trend to continue, both the Dow Industrials and the Dow Transports ‘must advance together" 6 A Trend Is Assumed to Be in Effect Until It Gives Definite Signals That It Has Reversed "This tenet, which we touched upon in Chapter 1, forms much of the foundation of modern trend-following approaches" "It relates a physical law to market movement, which states that an object in ‘motion (in this case a trend) tends to continue in motion until some external force causes it to change direction" "A number of technical tools are available to traders to assist in the difficult task of spotting reversal signals, including the study of support and resistance levels, price patterns, trendlines, and moving averages" Some indicators can provide even earlier warning signals of loss of ‘momentum "All of that not withstanding, the odds usually favor that the existing trend will continue" beaten a Figure 2 2 Examples of two Dow Theory confirmations "At the stat of 1997 (point 1), the Dov Transports confirmed the earlier breakout in the Industias" "The fllowing May (point 2), the Dow Industrials confirmed the ‘earlier new high in the Transport" "‘The most difficult task for a Dow theorist, or any trend-fol- lower for that matter, is being able to distinguish between a normal secondary correction in an existing trend and the frst leg of a new trend in the opposite direction" Dow theorists often disagree as to when the market gives an actual reversal signal Figures 2 3a and 2 3b show how this disagreement manifests itself Figures 2 3a and 2 3b illustrate two different market sce- narios In Figure 2 "3a, notice that the rally at point C is lower than the previous peak at A" Price then declines below point B ‘The presence of these two lower peaks and two lower troughs gives a clear-cut sell signal at the point where the low at B is bro- ken (point 5) This reversal pattern is sometimes referred to as @ “failure swing ” 30 Copter2 Figure 23a Failure Swing Figure 23b _Nonfaiure Swing Notice ‘The failure ofthe peak at 10 that C exceeds A before falling below B "cvercome A, followed by the Some Dow theorists would see a “sell” si- olation ofthe low at B,con- nal at ST, while others would need to see a stitutes a ""el"" signal at S" —_lower high at E Before turing bearish at 2 {In Figure 2 "3b, the rally top at C is higher than the previous peak at A" Then price declines below point B "Some Dow theorists ‘would not consider the clear violation of suppor, at S1, to be a bbona fide sell signal" "They would point out that only lower lows ‘exist in this case, but not lower highs" They would prefer to see a rally to point E which is lower than point C Then they would look for another new low under point D "To them, S2 would represent the actual sell signal with two lower highs and two lower lows" ‘The reversal pattern shown in Figure 2 3) is referred to as a “nonfailure swing ” A failure swing (shown in Figure 2 3a) is a much weaker pattern than the nonfailure swing in Figure 2 3b Figures 2 4a and 2 4b show the same scenarios at a market bottom THE USE OF CLOSING PRICES AND ‘THE PRESENCE OF LINES Dow relied exclusively on closing prices He believed that averages hhad to close higher than a previous peak or lower than a previous trough to have significance Dow did not consider intraday pene- trations vali ow Theory 31 Figure 24a Failure Swing Figure 2 4 Nonfilure Swing Bottom The “buy” signal takes place Bottom “Buy’ signals occur at points when point Bi exceeded (at BI) "‘BY or B2 ‘When traders speak of lines in the averages, they are ref ring to horizontal patterns that sometimes occur on the charts" ‘These sideways trading ranges usually play the role of corrective pphases and are usually referred to as consolidations "In more mod- fem terms, we might refer to such lateral patterns as “rectangles" "” SOME CRITICISMS OF DOW THEORY Dow Theory has done well over the years in identifying major Dull and bear markets, but has not escaped criticism" "On average, Dow Theory misses 20 to 25% of a move before generating a sig nal" Many traders consider this to be too late A Dow Theory buy signal usually occurs in the second phase of an uptrend as price penetrates a previous intermediate peak "This i also, incidentally, bout where most trend-following technical systems begin to Identify and participate in existing trends" "‘in response to this criticism, traders must remember that Dow never intended to anticipate trends; rather he sought to rec- ‘ognize the emergence of major bull and bear markets and to cap- ture the large middie portion of important market moves" 32 her 2 Available records suggest that Dow’s Theory has performed that function reasonably well "From 1920 to 1975, Dow Theory signals captured 68% of the moves in the Industrial and Transportation Averages and 67% of those in the S&P S00 Composite Index (Source: Barron's), Those who criticize Dow Theory for failing to ‘atch actual market tops and bottoms lack a basic understanding of the trend following philosophy" STOCKS AS ECONOMIC INDICATORS Dow apparently never intended to use his theory to forecast the direction of the stock market He felt ts real value was to use stock ‘market direction as a barometric reading of general business con- ditions We can only marvel at Dow's vision and genius "In addi- jon to formulating a great deal of today’s price forecasting methodology, he was among the first to recognize the usefulness ‘of stock market averages as a leading economic indicator" DOW THEORY APPLIED TO FUTURES TRADING Dow's work considered the behavior of stock averages "While ‘most of that original work has significant application to com- modity futures, there are some important distinctions between stock and futures trading" "For one thing, Dow assumed that most Investors follow only the major trends and would use intermedi- ate corrections for timing purposes only" "Dow considered the minor or near term trends to be unimportant, Obviously, this is not the case in futures trading in which most traders who follow ‘ends trade the intermediate instead of the major trend" These traders must pay a great deal of attention to minor swings for timing purposes "If a futures trader expected an intermediate uptrend to last for a couple of months, he or she would look for short term dips to signal purchases" "In an Intermediate down- trend, the trader would use minor bounces to signal short sales, ‘The minor trend, therefore, becomes extremely important in futures trading" NEW WAYS TO TRADE THE DOW AVERAGES "For the fist 100 years of Rs existence, the Dow Jones Industrial [Average Could only be used as 2 markt Indicator" "That all changed fon October 6, 1997 when futures and options began trading on ows venerable average for the first time" "The Chicago Board of Trade launched a futures contact on the Dow Jones Industrial [Average, while options on the Dow (symbot: D)X) started tading at the chicago Board Options Exchange" "In adstion, options were also launched on the Dow Jones Transporation Average (symbol: DTA) andthe Dow Jones Ut inex (symbol DIVA), In January 1998, the ‘American Stock Exchange started trading the Diamonds Trust, a unit {nvestment trust that mimics the 30 Dow industria, In addition, two ‘mutual funds were offered based on the 30 Dow benchmark, Me Dow would probably be happy to know that, a century after thei Creation, it would now be possible to trade his Dow averages, and, Setualy put his Dow Theory into practice" CONCLUSION ‘This chapter presented a relatively quick review of the more important aspects of the Dow Theory "It will become clear, as you continue through this book, that an understanding and apprecia- tion of Dow Theory provides a solid foundation for any study of technical analysis, Much of what is discussed in the following" ‘chapters represents some adaptation of Dow's original theory "The Standard definition of trend, the classification of a trend into three categories and phases, the principles of confirmation and divergence, the interpretation of volume, and the use of percent ‘age retracements (to name a few), all derive, in one way or anoth- er, from Dow Theory" "In addition to the sources already cited in this chapter, an excellent review of the principles of Dow Theory can be found in Technical Analysis of Stock Trends (Edwards & Magee)" Chart Construction ah INTRODUCTION ‘This chapter is primarily intended for those readers who are unfa- rillar with bar chart construction We'll begin by discussing the different types of charts available and then turn our focus to the ‘most commonly used chart—the daily bar chart We'll look at how the price data is read and plotted on the chart Volume and open Interest are also included in addition to price "We'll then look at ‘other variations of the bar chart, including longer range weekly and ‘monthly charts, Once that has been completed, we'll be ready to start looking at some of the analytical tools applied to that chart in the following chapter" Those readers already familiar with the charts themselves might find this chapter too basic Feel free to ‘move on to the next chapter 35 36 Chopter3 ‘TYPES OF CHARTS AVAILABLE ‘The daily bar chart has already been acknowledged as the most widely used type of chart in technical analysis "There are, how- lever, other types of charts also used by technicians, such as line chatts, point and figure charts, and more recently, candlesticks" Figure 3 1 shows a standard daily bar chart It called a bar chart because each day's range is represented by a vertical bar "The bar chart shows the open, high, low, and closing prices" The tie to the right of the vertical bar is the closing price The opening price is the tic to the left of the bar Figure 3 "2 shows what the same market looks like on a line ‘chart, In the line chart, only the closing price Is plotted for each successive day" "Many chartists believe that because the closing price is the most critical price of the trading day, a line (or close- only) chart is a more valid measure of price activity" Figure 3 1 A daly bar chart of Intel Each vertical bar represents one days action chart Construct 37 (ee Figure 3 2 _A line char of intel This type of chart produces a soli line Dy connecting the successive closing pics "‘A third type of chart, the point and figure chart, Is shown In Figure 3" 3 Notice here that the point and figure chart shows the same price action but in a more compressed format Notice the alternating column of x’s and o's "The x columns show rising prices and the o columns, declining prices" Buy and sel signals are ‘more precise and easier to spot on the point and figure chart than ‘on the bar chart This type of chart also has a lot more flexibility Chapter 11 covers point and figure charts CANDLESTICKS Candlestick charts are the Japanese version of bar charting and have become very popular in recent years among western chattists "The Japanese candlestick records the same four prices as the traditional bar chart—the open, the close, the high, and the remap cy Pom Fgee Coa Figure 3" 3 A point and figure chart of Intel Notce the altemating columns of Sand 0 The x column shows rising prices "The o column shows falling ‘prices, Buy and sel signals are more precise on this type of chart Jove" The visual presentation differs however "On the candlestick chart, a thin line (called the shadow) shows the day's price range from the high to the low" A wider portion of the bar (called the ‘real body) measures the distance between the open and the close "If the close is higher than the open, the real body is white (posi- tive)" "If the close is lower than the open, the real body 1s black (negative)" (See Figure 3 4 ) ‘The key to candlestick charts is the relationship between the open and the close "Possibly because of the growing popular- ity of candlesticks, western chartists now pay a lot more attention to the opening tic on their bar charts" You can do everything with 4 candlestick chart that you can do with a bar chart "In other ‘words, all the technical tools and indicators we'll be showing you for the bar chart can also be used on candlesticks" "We'll show you 4 bit later in the chapter how to construct bar charts for weekly hat Consuction 39 "" E ‘ny a We : a tall Figure 3A candlestick chart of ntl" The color ofthe candlestick is {termined by the relationship between the open and the close "White can “lestcks are positive, while lack candlestick ar negative" and monthly periods You can do the same with candlesticks "Chapter 12, “Japanese Candlesticks,” provides a more thorough explanation of candlestick charting" ARITHMETIC VERSUS LOGARITHMIC SCALE ‘Charts can be plotted using arithmetic or logarithmic price scales "For some types of analysis, particularly for very long range trend analysis, there may be some advantage to using logarithmic charts, See Figures 3" 5 and 3 6 ) Figure 3 5 shows what the differ- fent scales would look like "On the arithmetic scale, the vertical price scale shows an equal distance for each price unit of change" Rotice in this example that each point on the arithmetic scale is equidistant "On the log scale, however, note that the percentage 40 Chapter 3 Increases get smaller as the price Aommete Mengrtmtc | Cate increases The distance from % Me | pointe 1 to" "2 i the same as the dis *f tance from points 5 to 10 because 3 | they both represent the same dou: E_| ‘bing in price, For example, a move 'E | om ste toon an antec sate TE | woud be the same distance as a move from 30 10-38, even though st | the former represents a doubling in price, while the latter Is a" price aL "| Increase of only 10%, Prices ploted ton rato orlog scales show equal dis tances for sinilar percentage moves Forerample,a move from 10 10 20, 1L_| ""toon increase) would be: the ra >" SSmedstance on 2 Tog chart 3s eR8 A comparion of pave fom 20 "10 40 oF 40 10 80, aariieticand gait” Many stock market chart services sale Note te a pacing‘ og chats, wheres ftuts chat gate sale wie et Tes Services use arithmetic, Charting seal sho software packages allow both typet of seating: as shown in Figure 3" CONSTRUCTION OF THE DAILY BAR CHART ‘The construction of the daily bar chart is extremely simple The bbar chart is both a price and a time chart The vertical axis (the y axis) shows a scale representing the price of the contract The hor- izontal axis (the x axis) records the passage of time Dates are ‘marked along the bottom of the the chart Al the user has to do is plot a vertical bar in the appropriate day from the day's high to the ‘day's low (called the range) Place a horizontal tie to the right of ‘the vertical bar identifying the daily closing price (See Figure 3 7 ") The reason for placing the tic to the right of the bar Is to distinguish it from the opening price, which chartists record to ‘Chr Consrction 41 netic Seaing lew os i i Figure 3" 6 Longer view of Intel using two diffrent price scales The chart to the left shows the traditional arithmetic sale The chart on the right ‘hows a logarithmic scale Notice that the three year up trendline worked bet- feron the log chart the left of the bar "Once that day's activity has been plotted, the ‘user moves one day to the right to plot the next day’s action" Most ‘chart services use five day weeks "Weekends are not shown on the chart, Whenever an exchange is closed during the trading week, that day’s space is left blank" The bars along the bottom of the chart measure volume (See Figure 3 7 ") VOLUME [Another piece of important information should be included on the bar chart—volume, Volume represents the total amount of trading activity in that market for that day" "Its the total number ‘of futures contracts traded during the day or the number of com- ‘mon stock shares that change hands on a given day in the stock market, The volume is recorded by a vertical bar at the bottom of the chart under that day's price bar" A higher volume bar means sty Vane 6 — Hh atl wll ia = igure 3 7 A closer look at the Intel daily bar chart Each bar measures the day's price range "The opening price is marked by the small tic to the left “of each bar, Th closing te 1st the right" The bars along the bottom mea swe each days volume the volume was heavier for that day A smaller bar represents lighter volume "A vertical scale along the bottom of the chart is provided to help plot the data, as shown in Figure 3" 7 FUTURES OPEN INTEREST (Open interest is the total number of outstanding futures contracts that are held by market participants at the end of the day "Open interest isthe number of outstanding contracts held by the longs or the shorts, not the total of both" "Remember, because we're dealing with futures contracts, for every long there must also be a short ‘Therefore, we only have to know the totals on one side" "Open inter- cst is marked on the chart with a solid line along the bottom, ust ally just above the volume but below the price" See Figure 3 8 ) ida al Figure 3 8 A daly line char of a Treasury Bond futures contract The caer) bers along the bottom measure the total daly volume The solid Tine “org the mide represents the fotal outstanding open interest forthe ‘ieasury Bond futures market "wanda ul ‘Total Versus Individual Volume and Open Interest Numbers in Futures Futures chart services, along with most futures technicians, use Only the fotal volume and open interest figures, Although figures Gre available for each individual delivery month, the total figures for each commodity market are the ones that are used for fore- casting purposes" There |s a good reason for this "‘hn the early stages of a futures contract's life, volume and copen interest are usually quite small, The figures build up as the cEntract reaches maturity" "In the last couple of months before expiration, however, the numbers begin to drop again" "‘Obviously, traders have to liquidate open positions as the con- 44 haper 3 tract approaches expiration" "Therefore, the increase in the num- bers in the first few months of life and the decline near the end of trading have nothing to do with market direction and ate just a function of the limited life feature of a commodity futures con- tract" "To provide the necessary continuity in volume and open interest numbers, and to give them forecasting value, the total numbers are generally used" "(Stock charts plot total volume fig: ures, but do not include open interest" ") ‘Volume and Open Interest Reported a Day Late in Futures, Futures volume and open interest numbers are reported a day late" "Therefore, the chartist must be content with a day's lag in obtaining and interpreting the figures" "The numbers are usual- ly reported during the following day's trading hours, but too late for publication in the day's financial newspapers" "Estimated volume figures are available, however, after the markets close and are included in the following morning’s paper" "Estimated volume numbers are just that, but they do at least give the futures technician some idea of whether trading activity was heavier or lighter the previous day" "In the morning paper, therefore, what the reader gets Is the last day’s futures prices along with an estimated volume figure" "Official volume and ‘open interest numbers, however, are given for the day before" Stock chartists don’t have that problem Volume totals for stocks are immediately available ‘The Value of Individual Volume and Ops Interest Numbers in Futures ‘The individual open interest numbers in futures do provide valu- able information They tell us which contracts are the most liquid for trading purposes "As a general rule, trading activity should be lim- ited to those delivery months with the highest open interest" Months ‘with low open interest mumbers should be avoided "AS the term {mplies, higher open interest means that there is more interest in certain delivery months" hort Constracon 45 WEEKLY AND MONTHLY BAR CHARTS We've focused so far on the daily bar chart "However, be aware {hata bor chart can be constructed for any time period" "The intra- tay bar chart measures the high low, and lst prices for periods as Short as five minutes" The average daily bar chart covers from sx to nine months of price action "For longer range trend analysis, However, weekly and monthly bar charts must be used The value bf using these longer range chart is covered in Chapter 8, But the shethod of constructing and updating the charts i essentially the Same" (See Figures 39 and 3 "10) ‘On the weekly chart, one bar represents the price activity for the entire week" "On the monthly chart, each bar shows the eo a Figure 3" 9 _A weekly bar chart ofthe US Dollar Index Each bar repre sents one weeks pice data "By compressing the price dat, the weekly chart “Sltows or chart analysis of longer range price rend, usually inthe vicinity of five years" "ane - oro Ment Bar Chat it Wy Wr | ra A, Ww ‘WV iN a) wet Be ee Figure 3" 10 A monthly bar chart ofthe US Dollar Index Each bar vep- resents one month's price data "By compressing the data even farther, the ‘monthly chart allows chart analysis for periods as lng as twenty years" ‘entire month's price action "Obviously, weekly and monthly charts ‘compress the price action to allow for much longer range trend analysis, A weekly chart can go back as much as five years and a ‘monthly chart up to 20 years" It's simple technique that helps the ‘chartist study the markets from a longer range perspective—a valu able perspective that is often lost by relying solely on daily charts "CONCLUSION Now that we know how to plot a bar chart, and having intro- ‘duced the three basic sources of information—price, volume, and ‘open interest—we'te ready to look at how that data is interpreted" Remember that the chart only records the data "In itself, it has lit- (Chor Consrction 47 ‘tle value" It’s much like a paint brush and canvas "By themselves, they have no value, In the hands of a talented artist, however, they can help create beautiful images" Perhaps an even better Comparison is scalpel "In the hands of a gifted surgeon, it can help save lives" "In the hands of most of us, however, a scalpel is not only useless, but might even be dangerous" A chart can Decome an extremely useful tool in the art of skill of market fore casting once the rules are understood Let’s begin the process "In the next chapter, we'll ook at some of the basic concepts of trend ‘and what I consider to be the building blocks of chart analysis" "Basic Concepts of Trend DEFINITION OF TREND ‘The concept of trend is absolutely essential to the technical approach to matket analysis, All of the tools used by the chartist— Support and resistance levels, price patterns, moving averages, trenlines, ete, have the sole purpose of helping to measure the trend of the market for the purpose of participating in that trend" "We often hear such familiar expressions as “always trade in the direction of the trend,” “never buck the trend,” or “the trend is Your friend" ” So let's spend a little time to define what a trend is and classify it into a few categories "iin a general sense, the trend is simply the direction of the ‘market, which way it's moving, But we need a more precise defi- nition with which to work" "Fist of all, markets don’t generally ‘move in a straight line in any direction" Market moves are char- lacterized by a series of zigzags "These zigzags resemble a series of Successive waves with fairly obvious peaks and troughs, It is the direction of those peaks and troughs that constitutes market trend" "Whether those peaks and troughs are moving up, down, or side- “a 50 chapter ‘ays tells us the trend of the market" "An uptrend would be defined as a series of successively higher peaks and troughs; a downtrend is just the opposite, a series of declining peaks and troughs; hori- zontal peaks and troughs would identify a sideways price trend (Gee Figures 4" 1a-d ) Aaa My Figure 4 10 Example of a downtrend turning into an uptrend "The fist ""othe lft shows a downtrend" "From Apit 1996 to April 1997, the Janke traded sideways, During the summer 1997, the rend turmed up" "TREND HAS THREE DIRECTIONS ‘We've mentioned an uptrend, downtrend, and sideways trend for a very good reason, Most people tend to think of markets as being" ‘always in either an uptrend or a downtrend "The fact of the mat- ter is that markets actually move in three directions—up, down, land sideways, It is important to be aware of this distinction because for at least a third of the time, by a conservative estimate, prices move in a flat, horizontal pattern that Is referred to as a trading range" This type of sideways action reflects a period of equi- librium in the price level where the forces of supply and demand are in a state of relative balance "(If you'll recall, Dow Theory refers to this type of pattern as a line" ") Although we've defined a flat market as having a sideways trend, it is more commonly referred to as being trendless" "Chapters ‘Most technical tools and systems are trend-following in nature, which means that they are primarily designed for markets that are moving up or down" "They usually work very poorly, or not at all, when markets enter these lateral or “trendless” phases, Its during these periods of sideways market movement that tech: nical traders experience their greatest frustration, and systems traders their greatest equity losses" "A trend-following system, by its very definition, needs a trend in order to do its stuff" The fail ture here lies not with the system "Rather, the failure lies with the trader who is attempting to apply a system designed for trending markets into a nontrending market environment" "There are three decisions confronting the trader—whether to buy a market (go long), sell a market (go short), or do nothing (stand aside)" "When a market is rising, the buying strategy is preferable" "When it is falling, the second approach would be cor- rect" "However, when the market is moving sideways, the third choice— {to stay out of the market—is usually the wisest" "TREND HAS THREE CLASSIFICATIONS In addition to having three directions, trend is usually broken down into the three categories mentioned in the previous chap- ter" "Those three categories ate the major, intermediate, and near term tends" "In reality, there are almost an infinite number of trends interacting with one another, from the very short term tends covering minutes and hours to superlong trends lasting 5 (or 100 years" "Most technicians, however, limit trend classfica- tions to three" "There is a certain amount of ambiguity, however, as to how different analysts define each trend" "Dow Theory, for example, classifies the major trend as being {n effect for longer than a year" "Because futures traders operate in a shorter time dimension than do stock investors, 1 would be Inclined to shorten the major trend to anything over six months in the commodity markets" "Dow defined the intermediate, or sec- ondary, trend as three weeks to as many months, which also appears about right for the futures markets" The near term trend is usually defined as anything less than two or three weeks ase Concepts of Tend 53 Each trend becomes a portion of its next larger trend "For ‘example, the intermediate trend would be a conection in the major trend" "In a long term uptrend, the market pauses to correct itself for a couple of months before resuming its upward path" That sec- ‘ondary correction would itself consist of shorter waves that would be identified as near term dips and rallies This theme recurs many times—that each trend is part of the next larger trend and is itself ‘comprised of smaller trends (See Figures 4 2a and b ) In Figure 4 "2a, the major trend Is up as reflected by the ris ing peaks and troughs (points 1, 2, 3, 4)" The corrective phase (2- 3) represents an intermediate correction within the major ‘uptrend "But notice that the wave 2-3 also breaks down into three ‘smaller waves (A, B, C)" "At point C, the analyst would say that the ‘major trend was still up, but the intermediate and near term trends were down" "At point 4, all three trends would be up" It is important to understand the distinction between the various ‘degrees of trend "When someone asks what the trend is in a given ‘market, itis difficult, {not impossible, to respond until you know 4 H Figure 4" "20 Example ofthe tre deres of tend: major, secondary, and rear term" "Points 1,2, 3, and 4 show the major uptrend" Wave 23 represents {secondary conection within the majr uptrend "Bach secondary wave i tum ves into new term trends, For example, secondary wave 2-3 divides into ‘minor waves A-B-C" Figure 4 26 The major tend (over a year) is up during 1997 A short term conection occured during March An intermediate corection lasted {from August to November (Ones months) The intermediate conection broke ‘down into thee shot term tends which trend the person is inquiring about You may have to respond in the manner previously discussed by defining the three different trend classifications Quite a bit of misunderstanding arises because of different ‘traders’ perceptions as to what is meant by a trend "To long term position traders, afew days’ toa few weeks' price action might be insignificant, To a day trader, a two or three day advance might constitute 2 major uptrend" "It’s especially important, then, to understand the different degrees of trend and to make sure that all involved in a transaction are talking about the same ones" "‘As a general statement, most trend-following approaches focus on the intermediate trend, which may last for several ‘months" The near term trend is used primarily for timing purpos- ¢s "In an intermediate uptrend, short term setbacks would be used to Initiate long positions" "aie Concepts of Tend 55 IPPORT AND RESISTANCE In the previous discussion of trend, it was stated that prices move in a series of peaks and troughs, and that the direction of those ‘peaks and troughs determined the trend of the market" "Let’s now {ive those peaks and troughs their appropriate names and, at the Same time, Introduce the concepts of support and resistance" """The troughs, or reaction lows, ae called support" The term is self-explanatory and indicates that support isa level or area on "the chart under the market where buying interest is sufficiently Strong to overcome selling pressure, AS a result, a decline is halt- ‘ed and prices turn back up again" Usually a support level is iden: tified beforehand by a previous reaction low In Figure 4 "3a, points 2 and 4 represent support levels in an uptrend" (See Figures 43a and b ) ‘Resistance is the opposite of support and represents a price level or area over the market where selling pressure overcomes buy- ing pressure and a price advance is turned back Usually a resis- Figure 4 3 Shows rising support and resistance levels in uptrend Points and 4 are support levels which are usually previous reaction lows "Points 1 ‘and 3 are resistance levels, usually marked by previous peaks 2__ Resistance Figure 4" 36 Shows support and resistance ina downtrend tance level is identified by a previous peak "In Figure 43a, points ‘Vand 3 are resistance levels" Figure 4 3a shows an uptrend "In an uptrend, the support and resistance levels show an ascending pat- tem" Figure 4 30 shows a downtrend with descending peaks and troughs "In the downtrend, points 1 and 3 are support levels under the market and points 2 and 4 are resistance levels over the market in an uptrend, the resistance levels represent pauses in that uptrend and are usually exceeded at some point" "In a downtrend, support levels are not sufficient to stop the decline permanentiy, but are able to check it at least temporaily" "A solid grasp of the concepts of support and resistance is necessary for a full understanding of the concept of trend, For an uptrend to continue, each successive low (support level) must be higher than the one preceding it" Each rally high (resistance level) ‘must be higher than the one before it "If the corrective dip in an uptrend comes all the way down to the previous low, It may be an carly warning that the uptrend is ending or at least moving from an uptend to 2 sideways trend" "If the support level is violated, then a trend reversal from up to down is likey Bose Concepts of Tend 57 Fach time a previous resistance peak is being tested, the uptrend is in an especially critical phase" "Fallure to exceed a pre- ‘ous peak in an uptrend, or the ability of prices to bounce off the previous support Iow in a downtrend, is usually the frst warning That the existing trend is changing" Chapters § and 6 on price pat- tems show how the testing of these support and resistance levels form pictures on the charts that suggest either a trend reversal in progress or merely a pause in the existing trend But the basic Building blocks on which those price patterns are based are sup port and resistance levels Figures 4 "4a-c are examples of a classic trend reversal Notice, in Figure 44a, that at point 5 prices failed to exceed the previous peak (point 3) before turning down to violate the previ Bus low at point 4, This trend reversal could have been identified Simply by watching the support and resistance levels" "In our cov- ‘rage of price patterns, this type of reversal pattern will be ident fied as a double top" How Support and Resistance Levels Reverse Their Roles So far we've defined “support” as a previous low and “resistance” as a previous high "However, this is not always the case" This leads ts to one of the more interesting and lesser known aspects of sup- port and resistance-—their reversal of roles Whenever a support or Figure 44a Example lofts tend reversal The failure of prices at point 'S to exceed the previous ‘peak at point 3 followed bya downside violation (ofthe previous low at point 4 constites @ ‘downside rend reversal ‘This typeof patter is called a double tp Figure 4 4b Example of« bottom reversal pattern Usually the fist sign ‘fa bottom i the ability of prices at point to hold above the previous low ‘point 3 The bottom is confirmed when the peak at 4 is overcome Figure 4 4¢ Example of a bottom reversal During January 1998 prices ‘retested the December support low and bounced off it forming a second Sup- ‘ort level "The upside penetration of the mide resistance peak signaled a new uptrend, Basle Concepts of Tend 59 resistance level is penetrated by a significant amount, they reverse their roles and become the opposite" "In other words, a resistance level becomes a support level and support becomes resistance" "To understand why this occurs, perhaps it would be helpful to dis- ‘cuss some of the psychology behind the creation of support and resistance levels" "‘The Psychology of Support and Resistance ‘To illustrate, le’s divide the market participants into three cate- sgories—the longs, the shorts, and the uncommitted" The longs dre those traders who have already purchased contracts; the Shorts are those who have already committed themselves to the sell side; the uncommitted are those who have either gotten out of the market or remain undecided as to which side to enter Let's assume that a market starts to move higher from a ‘support area where prices have been fluctuating for some time "‘The longs (those who bought near the support area) are delight~ ed, but regret not having bought more" "If the market would dip back near that support area again, they could add to their long positions" The shorts now realize (or strongly suspect) that they lire on the wrong side of the market "(How far the market has ‘moved away from that support area will greatly influence these decisions, but we'll come back to that point a bit later" ) The shorts are hoping (and praying) for a dip back to that area where they ‘went short so they can get out of the market where they got in (their break even point) "‘Those sitting on the sidelines can be divided into two ‘sroups—those who never had a position and those who, for ‘One teason or another, liquidated previously held long posi- tions in the support area" "The latter group are, of course, mad at themselves for liquidating their longs prematurely and are hoping for another chance to reinstate those longs near where they sold them" "“The final group, the undecided, now realize that prices are ‘going higher and resolve to enter the market on the long side on the next good buying opportunity" All four groups are resolved to “buy the next dip ” They all have a “vested interest” in that sup- 60 hopter 4 port area under the market "Naturally, if prices do decline near that support, renewed buying by all four groups will materialize to push prices up, ‘The more trading that takes place in that support area, the ‘more significant it becomes because more participants have a vested interest in that area" "The amount of trading in a given sup- port or resistance area can be determined in three ways: the amount of time spent there, volume, and how recently the trad- Ing took place" "‘The longer the period of time that prices trade in a support or resistance area, the more significant that area becomes, Fot example, if prices trade sideways for three weeks in a congestion area before ‘moving higher, that support area would be more important than if only three days of trading had occurred, Volume is another way to measure the significance of support and resistance" "If a support level is formed on heavy volume, this would indicate that a large number of units changed hands, and would mark that support level as more important than if very lit- te trading had taken place" "Point and figure charts that measure the intraday trading activity are especially useful in identifying ‘these price levels where most of the trading took place and, con- sequently, where support and resistance will be most likely to function, A third way to determine the significance of a support or resis- tance area is how recently the trading took place" "Because we are deal- ing with the reaction of traders to market movement and to posi- tions that they have already taken or falled to take, it stands to reason that the more recent the activity, the more potent it becomes, ‘Now let's turn the tables and imagine that, instead of mov- ing higher, prices move lower" "In the previous example, because prices advanced, the combined reaction of the market partici- ppants caused each downside reaction to be met with additional buying (thereby creating new support)" "However, if prices start to drop and move below the previous support area, the reaction becomes just the opposite" All those who bought in the support area now realize that they made a mistake "For futures traders, their brokers are now calling frantically for more margin money, ase Concepts of Tend 61 Because of the highly leveraged nature of futures trading, traders cannot sit with losses very long" They must put up additional ‘margin money ot liquidate their losing positions "‘What created the previous support in the first place was the predominance of buy orders under the market, Now, howev- tr, all of the previous buy orders under the market have become Sell orders over the market" Support has become resistance "And the ‘ore significant that previous support area was—that is, the more recent and the more trading that took place there—the more potent It now becomes as a resistance area" "All of the factors that Created support by the three categories of participants—the longs, the shorts, and the uncommitted—will now function to put a cell- ing over prices on subsequent rallies or bounces" "Tt is useful once in a while to pause and reflect on why the price patterns used by chartists, and concepts like support and Fesistance, actually do work" I's not because of some magic pro- ‘Guced by the charts or some lines drawn on those charts "These patterns work because they provide pictures of what the market participants are actually doing and enable us to determine their Feactlons to market events, Chart analysis is actually a study of hhuman psychology and the reactions of traders to changing mar- Ket conditions, Unfortunately, because we live in the fast-paced ‘world of financial markets, we tend to rely heavily on chart ter- inology and shortcut expressions that overlook the underlying forces that created the pictures on the charts in the first place" """There are sound psychological reasons why support and resistance Tevels can be identified on price charts and why they can be used to help predict market movements" "‘Support Becoming Resistance and Vice Versa: Degree of Penetration 'A support level, penetrated by a significant margin, becomes 2 resistance level and vice versa" Figures 4 "5a-c are similar to Figures ‘43a and b but with one added refinement, Notice that as prices are rising in Figure 4" Sa the reaction at point 4 stops at or above ‘the top of the peak at point 1 That previous peak at point 1 had ‘been a resistance level But once it was decisively penetrated by 62 Chapter 4 Figure 4 "$a In an uptrend, resistance levels that have been broken by a significant margin become support levels" "Notice that once resistance at point 11 exceeded, If provides support at point 4 Previous peaks function as Sup" orton subsequent crections Figure 4 "5b na downtrend, violated support levels become resistance les 15 on subsequent bounces" Notice how previous support at point 7 became resistance at point 4 ee Figure 4 5 Role reversal at play Once the early 1997 resistance peak Fierroken it reversed roles to become a support level "A year late, the inter« Tralee price decline found suppor right at that prior resistance peak which Thad Become new support" "wave 3, that previous resistance peak became a support level" All Of the previous selling near the top of wave 1 (creating the resis- tance level) has now become buying under the market "In Figure {2'sb, showing declining prices, point 1 (Which had been @ previ- dus support level under the market) has now become a resistance evel over the market acting as a ceiling at polnt 4" it was mentioned earlier that the distance prices traveled away from support or resistance increased the significance of that Support or resistance This is particularly true when support and Teuistance levels are penetrated and reverse roles "For example, it ‘was stated that support and resistance levels reverse roles only’ Sfter a significant penetration" But what constitutes significant? There Is quite a bit of subjectivity Involved here in determining whether a penetration is significant or not "Asa benchmark, some hartists use a 3% penetration as a criteria, particularly for major support and resistance levels" "Shorter term support and resistance areas would probably require a much smaller number, like 1%" "In reality, each analyst must decide for himself or herself what con- stitutes a significant penetration" "It's important to remember, however, that support and resistance areas only reverse roles when the market moves far enough away to convince the market Participants that they have made a mistake" "The farther away the market moves, the more convinced they become" ‘The Importance of Round Numbers as ‘Support and Resistance There is a tendency for round numbers to stop advances or declines "Traders tend to think in terms of important round num- bers, such as 10, 20, 25, $0, 75, 100 (and multiples of 1000), as price objectives and act accordingly" "These round numbers, there- fore, will often act as “psychological” support or resistance levels, A trader can use this information to begin taking profits as an Important round number is approached" ‘The gold market is an excellent example of this phenome- non The 1982 bear market low was right at $300 The market then rallied to just above $500 in the first quarter of 1983 before falling to $400 A gold rally in 1987 stopped at $500 again "From 1990 to 1997, gold failed each attempt to break through $400, The Dow Jones Industrial Average has shown a tendency to stall at multiples of 1000" ‘One trading application of this principle is to avoid placing wading orders right at these obvious round numbers "For example, It the trader is trying to buy into a short term market dip in an uptrend, it would make sense to place limit orders just above an important round number" "Because others are trying to buy the market at the round number, the market may never get there" ‘Traders looking to sell on a bounce should place resting sell orders Just below round numbers "The opposite would be true when Placing protective stops on existing positions, As a general rule, ‘avoid placing protective stops at obvious round numbers" "Base Concepts of Tend 6s In other words, protective stops on long positions should be placed below round numbers and on short positions, above Bich numbers, The tendency for markets to respect round num- pers, and especially the more important round numbers previous- Iy referred to, Is one of those peculiar market characteristic that Can prove most helpful in trading and should be kept in mind by the technically oriented trader" "TRENDLINES Now that we understand support and resistance, let's add mmother building block to our arsenal of technical tools—the irondline" (See Figures 4 6a-c ") The basic trendline ts one of the Simplest of the technical tools employed by the chartist, Dut is iso one of the most valuable" An up trendline is a straight line Grawn upward to the right along successive reaction lows as Shown by the solid line in Figure 4 63 A down trendline is drawn Spaenward to the right along successive rally peaks as shown in Figure 4 6b Figure 4 60 Example of an up trend line The up vende is ra under he rising reaction lows "A tent tie tein fist trawn ander 0 suces- sively higher lows (points 1 and 3), but neds a ‘hid tet to confirm the vali of the tendine (point 9 Figure 4" 6¢ Long tem up trenline at work "The up trendline was drawn ""upward and tothe right along the fst two reaction lows (sce arrows)" "The ‘third low at the tart of 1998 bounced right off he rising trendline, thereby Aeeping the uptrend intact ke Concepts of Tend 67 Drawing a Trendline ‘The correct drawing of trendlines isa lot like every other aspect of, charting and some experimenting with different lines Is usually rnecessary to find the correct one" Sometimes a trendline that looks correct may have to be redrawn But there are some useful ‘guidelines in the search for that correct line "First of all, there must be evidence of a trend" "This means that, for an up trendline to be drawn, there must be at least two reaction Jows with the second low higher than the fist" "Of course, it always takes two points to draw any straight line" In Figure 4 "68, for example, only after prices have begun to move higher from point 3{s the chartist reasonably confident that a reaction low has been formed, and only then can a tentative up trendline be drawn under points 1 and 3" ‘Some chartists require that the peak at point 2 be penetrat- ed to confirm the uptrend before drawing the trendline "Others ‘only require a 50% retracement of wave 2-3, or that prices approach the top of wave 2, While the criteria may differ, the main point to remember is that the chartist wants to be reasonably sure that a reaction low has been formed before identifying a valid reaction Tow" "Once two ascending lows have been identified, a straight line is drawn connecting the lows and projected up and to the right" "‘Tentative Versus the Valid Trendline So far, all we have is a tentative trendline" "in ordet to confirm the validity of a trendline, however, that line should be touched a third time with prices bouncing off of it" "Therefore, in Figure 4" "63, the successful test of the up trendline at point 5'confirmed the validity of that line" Figure 4 "6b shows a downtrend, but the rules fare the same, The successful test of the trendline occurs at point 'S" "To summarize, two points are needed to draw the trendline, land a third point to make ita valid trendline" "How to Use the Trendline ‘Once the third point has been confirmed and the trend proceeds in its original direction, that trendline becomes very useful in a cy reper variety of ways" One of the basic concepts of trend is that a trend {in motion will tend to remain in motion "As a corollary to that, ‘once a trend assumes a certain slope or rate of speed, as identified by the trendline, it will usually maintain the same slope" "The {endline then helps not only to determine the extremities of the corrective phases, but maybe even more importantly, tells us when that trend Is changing" "In an uptrend, for example, the inevitable corrective dip ‘will often touch or come very close to the up trendline, Because the intent of the trader is to buy dips in an uptrend, that trend- line provides a support boundary under the market that can be used as a buying area" A down trendline can be used as a resis> tance area for selling purposes (See Figures 4 "7 and b,) As long as the trendline is not violated, it can be used to determine buying and selling areas" "However, at point 9 in Figures 4" "7acb, the violation of the trendline signals a trend change, call" ing for liquidation of all positions in the direction of the previous lend "Very often, the breaking of the trendline 1s one ofthe best early warnings of a change in trend" Figure 4 "7a Once the up trendline has been established, subsequent dips ear the ine can be sed a buying areas" Points S and 7 tn this example ould ‘have been used for new or addtional longs The breaking ofthe enline at point 9 called for liquidation ofall longs by signaling a downside tend reversal ase Concepts of Tend 69 am Points Sand 7 could have been used as selling areas "The breaking ofthe trendline at pont 9 signaled an upside ‘vend reversal How to Determine the Significance of a Trendline Let's discuss some of the refinements of the trendline, First, what determines the significance of a trendline? The answer to that {question is twofold—the longer it has been intact and the number of thes it has been tested" "A trendline that has been successfully test- ‘ed eight times, for example, that has continually demonstrated its Validity, is obviously @ more significant trendline than one that hhas only been touched three times" "Also, a trendline that has been in effect for nine months is of more importance than one that has been in effect for nine weeks or nine days" "The more significant the trendline, the more confidence it inspires and the more important Is its penetration" ‘Trendlines Should Include All Price Action ‘Trendlines on bar charts should be drawn over or undler the entire day's price range "Some chattists prefer to draw the trendline by Connecting only the closing prices, but that is not the more stan- ard" procedure "The closing price may very well be the most important price of the day, but it stil represents only a small sam- ple of that day’s activity" The technique of including the day's price range takes into account all of the activity and fs the more ‘common usage (See Figure 4 8 ) it Figure 4 8 The correct drawing ofa trendline Should include th entire days trading range "How to Handle Small Trendline Penetrations Sometimes prices will violate a trendline on an intraday basis, but then close in the direction of the original trend, leaving the analyst {in some doubt as to whether or not the trendline has actually been broken" (See Figure 4 9 ) Figure 4 9 shows how such a situation might look "Prices did dip under the trendline during the day, but closed ‘back above the up trendline" Should the trendline be redrawn? Figure 4 9 Sometimes an intraday violation ofa trendline will eave the ‘hartistin doubt as to whether the orginal tendline (ssl valid orf a new {ine should be draw "A compromise isto kep the original tein, but draw ‘mew dotted tine until it canbe beter determined which is the tre line" "osc Concepts of Tend ” Unfortunately, there's no hard and fast rule to follow in such a situation" "Sometimes it is best to ignore the minor breach, fspecially if subsequent market action proves that the original Tine is stil valid" "‘What Constitutes a Valid Breaking of a Trendline? ‘As a general rule, a close beyond the trenline is more significant than just an intraday penetration" "To go a step further, sometimes even a Closing penetration is not enough" Most technicians employ a Variety of time and price filters in an attempt to isolate valid trendline penetrations and eliminate bad signals or “whipsaws "” ‘One example of a price filter is the 396 penetration criteria, This price filter is used mainly for the breaking of longer term trend Fines, but requires that the trendline be broken, on a closing basis, by at least 3%" "(The 3% rule doesn’t apply to some financial fatures, such as the Interest rate markets" ") ""if, for example, gold prices broke a major up trendline at $400, prices would have to close below that line by 3% of the price level where the line was broken (in this case, prices would Rave to close $12 below the trendline, or at $388)" "Obviously, a $12 penetration criterla would not be appropriate for shorter term" "trading, Pethaps a 1% criterion would serve better in such cases" "The 9 rule represents just one type of price filter Stock chartsts, for example, might require a full point penetration and ignore fractional moves, There is tradeoff involved in the use of any type of filter" "Ifthe filter is too small, it won't be very useful in reduc- {ng the impact of whipsaws" "If t's too big, then much of the ini- tial move will be missed before a valid signal is given" "Here again, the tader must determine what type of filter is best suited to the ‘degree of trend being followed, always making allowances for the differences in the individuals markets ‘An alternative to a price filter (requiring that a trendline be broken by some predetermined price Increment or percentage amount) is a time filter" A common time filter is the two day rue "In other words, to have a valid breaking of a trendline, prices imust close beyond the trendline for two successive days" "To break Rm Chapters an up trendline, therefore, prices must close under the trendline ‘wo days in a row" A one day violation would not count "The 1- 39% rule and the two day rule are also applied to the breaking of important support and resistance levels, not just to major trend- lines" Another filter would require a Friday close beyond a major breakout point to ensure a weekly signal "How Trendlines Reverse Roles It was mentioned earlier that support and resistance levels became the opposite once violated, The same principle holds true of trendlines" (See Figures 4 10a-c ") In other words, an up trendline {a support line) will usually become a resistance line once it’s dect- sively broken" A down trendline (a resistance line) will often become a support line once i's decisively broken This is why it's ‘usually a good idea to project all trendlines as far out to the right fon the chart as possible even after they’ve been broken "It's sur- rising how often old trendlines act as support and resistance Jines again in the future, but in the opposite role" Measuring Implications of Trendlines ‘Trendlines can be used to help determine price objectives We'll have alot more to say about price objectives in the next two chap- Figure 4 100 Example of arising ‘support line becom ing resistance "Usually a support ine wit function as ‘resistance barrier (on subsequent ral- Ties, after thas" "‘been broken on the downside sk Concepts of Tend 73 4100 Verena down bene wi come tie oc ben Proto onthe ee =a a Bar Chart \ om rh | rl i | \! iM | 1 i L | in ("" r | etd ‘Figure 4" 10¢ Trendlines also reverse roles "On this chart, the broke ip Taline Became a resistance barrier on the following rally attempt" 74 Copter ters on price patterns "In fact, some of the price objectives addressed that are derived from Various price patterns are similar to the one we'll cover here with trendlines, Stated briefly, once a trendline is broken, prices will usually move a distance beyond the trendline equal to the vertical distance that prices achieved on, the other side of the line, prior to the trend reversal In other words, if in the prior uptrend, prices moved $50 above the up trendline (measured vertically), then prices would be expected to drop that same $50 below the trendline after it’s broken" "In the next chapter, for example, well see that this measuring rule using the trendline is similar to that used for the well-known head “and shoulders reversal pattern, where the distance from the “head” to the “neckline” is projected beyond that line once it’s broken" THE FAN PRINCIPLE ‘This brings us to another interesting use of the trendline—the fan ‘Principle (See Figures 4 11a-c ") Sometimes after the violation of an Lup trendline, prices will decline a bit before rallying back to the bottom of the old up trendline (now a resistance line)" In Figure 4 "11a, notice how prices rallied to but failed to penetrate line 1" A Figure 4 110 Example ofthe fan principle The breaking of the third trendline signals the reversal ofa tend Notice aso thatthe broken trend lines and 2 often become resistance lines "Bose Concepts of Tend 7s 1a bottom, The breaking ofthe third Figure 4" 11b The fan principle a “Te previously broken tenis trendline signals the upside tend reversal {2 and 2) often become support levels atte Fam lines ae drawn along successive peaks as shown in is Fig brekiy of the tind fa Tine usualy signals the start of the uptrend "76 Chapter second trendline (line 2) can now be drawn, which is aso broken" "After another failed rally attempt, a third line is drawn (line 3)" ‘The breaking of that third trendline is usually an indication that prices are headed lower In Figure 4 "11, the breaking of the third down ‘trendline (line 3) constitutes a new uptrend signal" Notice in these ‘examples how previously broken support lines became resistance and resistance lines became support "The term “fan principle” pletion of market tops But" "at some point, volume should begin to Increase if the new downtrend fs to be continued" "Volume pays 9 much more decisive role at market bottoms, a subject to be dis cussed shortly Before doing 50, however, let's discuss the measur ing implications of the head and shoulders patter" FINDING A PRICE OBJECTIVE ‘The method of arriving at a price objective is based on the height of the pattern Take the vertical distance from the head (point C) to the neckline Then project that distance from the point where the neckline is broken "Assume, for example, that the top of the head is at 100 and the neckline is at 80" "The vertical distance, therefore, ould be the difference, which is 20" That 20 points would be mea: sured downward from the level at which the neckline is broken If the neckline in Figure S "1a is at 82 when broken, a downside objec- tive would be projected to the 62 level (82 ~ 20 = 62)" "Another technique that accomplishes about the same task, ‘but i a bit easier, isto simply measure the length of the first wave Of the decline (points C to D) and then double it" "In either case, the greater the height or volatility of the pattern, the greater the ‘objective" Chapter 4 stated that the measurement taken from a trendline penetration was similar to that used in the head and shoulders pattern You should be able to see that now Prices trav- 1 roughly the same distance below the broken neckline as they do above it You'll see throughout our entire study of price pat- ‘terns that most price targets on bar charts are based on the height or Moje Revel Patterns 109 volatility ofthe various patterns The theme of measuring the height Of the pattern and then projecting that distance from a breakout point will be constantly repeated """i's important to remember that the objective arrived at is only «a minimum target" Prices will often move well beyond the objec tive "Having 2 minimum target to work with, however, Is very: helpful in determining beforehand whether there is enough potential in a market move to warrant taking a position" "If the fnarket exceeds the price objective, that’s just icing on the cake" The maximum objective is the size of the prior move "If the previ- ‘ous bull market went from 30 to 100, then the maximum down- Side objective from a topping pattern would be a complete etracement of the entire upmove all the way down to 30" Reversal patterns can only be expected to reverse or retrace what has gone before them Adjusting Price Objectives [A number of other factors should be considered while trying t© arrive at a price objective "The measuring techniques from price patterns, such as the one just mentioned for the head and shoul- Gers top, are only the first step" There are other technical factors to take into consideration "For example, where are the prominent ‘support levels left by the reaction lows during the previous bull ‘move? Bear markets often pause at these levels" What about per- centage retracements? The maximum objective would be a 100% rettacement of the previous bull market But where are the 509% dnd 66% retracement levels? Those levels often provide signifi- ant support under the market What about any prominent gaps underneath? They often function as support areas Are there any Jong term trendlines visible below the market? ‘The technician must consider other technical data in try- {ng to pinpoint price targets taken from price patterns "If a down- side price measurement, for example, projects a target to 30, and there is a prominent support level at 32, then the chartist would be wise to adjust the downside measurement to 32 instead of 30" "vas a general rule, when a slight discrepancy exists between @ pro~ jected price target and a clearcut support or resistance level, it's 110 Copter $ usually safe to adjust the price target to that support or resistance level" It is often necessary to adjust the measured targets from pice patterns to take into account additional technical informa- tion The analyst has many different tools at his or her disposal The most skillful technical analysts are those who learn to blend all of those tools together properly "THE INVERSE HEAD AND SHOULDERS ‘The head and shoulders bottom, or the inverse head and shoulders asit Is sometimes called, is pretty much a mirror image of the top- ping pattern" As Figure § "2a shows, there are three distinct bot- Figure 8" 20 Example of an inverse head and shoulders The bottom ver son ofthis pattern ia mirror image ofthe tp The only significant difer- fence 1s the volume patter inthe second haf of he pattern "The rally from ‘the head should see heavier volume, and the breaking of the neckline should sce bust of tating activity" The return move back tthe neckline s more common at botoms Mojo Revel Potters mn toms with the head (middle trough) a bit lower than either of the two shoulders "A decisive close through the neckline is also nec- ‘essary to complete the pattern, and the measuring technique is the same" One slight difference at the bottom is the greater ten- ddeney for the return move back to the neckline to occur after the bullish breakout (See Figure 5 2 ) “The most important difference between the top and bot- ‘tom patterns is the volume sequence Volume plays a much more Critical role in the identification and completion of a head and ‘Shoulders bottom This point is generally true of all bottom pat: terns It was stated earlier that markets have a tendency to “fall of their own weight "” At bottoms, however, markets require a signif- jcant increase in buying pressure, reflected in greater volume, to launch a new bull market" =) \\ (tain el i i — id Ws Figure 5 "26 A head and shoulders botiom, The neckline has a slight downward slant, which is normally the case" "The pullback aftr the breakout (Gee arow) nicked the neckline abit, but ten resumed the uptrend mz hoper$ ‘A more technical way of looking at this difference is that ‘a market can fall just from inertia" Lack of demand or buying interest on the part of traders is often enough to push a market lower; but a market does not go up on inertia Prices only rise when’ demand exceeds supply and buyers are more aggressive than sellers ‘The volume pattern at the bottom is very similar to that at the top for the first half of the pattern "That is, the volume at the head is a bit lighter than that at the left shoulder" "The rally from the head, however, should begin to show not only an increase in trading activity, but the level of volume often exceeds ‘that registered on the rally from the left shoulder" The dip to the right shoulder should be on very light volume The critical point ‘occurs at the rally through the neckline This signal must be accompanied by a sharp burst of trading volume if the breakout 4s for real ‘This point is where the bottom differs the most from the top "At the bottom, heavy volume is an absolutely essential ingredient in the completion of the basing pattern" The return ‘move is more common at bottoms than at tops and should occur on light volume "Following that, the new uptrend should resume (on heavier volume" The measuring technique is the same as at the top ‘The Slope of the Neckline The neckline at the top usually slopes slightly upward "Sometimes, however, it is horizontal" "In either case, it doesn’t ‘make too much of a difference" "Once in a while, however, a top neckline slopes downward" This slope is a sign of market weakness and is usually accompanied by a weak right shoulder "However, this is a mixed blessing" "The analyst waiting for the breaking of the neckline to initiate a short position has to wait a bit longer, because the signal from the down sloping neckline occurs much later and only after much of the move has already taken place" "For basing pattems, most necklines have a slight downward tlt" "A ris- ing neckline is'a sign of greater market strength, but with the same drawback of giving a later signal" Major Reversal Paters 113 COMPLEX HEAD AND SHOULDERS PATTERNS ‘A variation of the head and shoulders pattern sometimes occurs ‘which is called the complex head and shoulders pattern These are patterns where two heads may appear or a double left and right shoulder "These patterns are not that common, but have the same forecasting implications" "A helpful hint in this regard is the strong, tendency toward symmetry in the head and shoulders patter" "‘This means that a single left shoulder usually indicates a single right shoulder, A double left shoulder increases the odds of a dou- ble right shoulder" ‘Tactics Market tactics play an important role in all trading Not all tech- nical traders like to wait for the breaking of the neckline before initiating a new position As Figure 5 "3 shows, more aggressive traders, believing that they have correctly identified a head and shoulders bottom, will begin to probe the long side during the formation of the right shoulder" Or they will buy the first techni- cal signal that the decline into the right shoulder has ended ‘Some will measure the distance of the rally from the bottom of the head (points Cto D) and then buy a 50% of 6696 retracement ‘of that rally Still others would draw a tight down trendline along the decline from points D to E and buy the first upside break of that trendline "Because these patterns are reasonably symmetrical, some will buy Into the right shoulder as it approaches the same level as the bottom of the left shoulder" A lot of anticipatory buying takes place during the formation of the right shoulder "Ifthe initial long probe proves to be profitable, additional positions can be added on the actual penetration of the neckline or on the return move back to the neckline after the breakout, ‘The Falled Head And Shoulders Pattern Once prices have moved through the neckline and completed a head and shoulders pattern, prices should not recoss the neckline 114 Chapters Figure 8" 3 Tactics fora head and shoulders bottom Many technical ‘traders will begin to initiate long positions while the right shoulder (B) is Stil being formed "One-half to two-thirds pullback ofthe rally fom points Cto_D, a decline tothe same level asthe left shoulder at point A, oF the ‘breaking ofa short term down trendline (line 1) all provide early epportuni- ties fr market entry" More positions can be added om the breaking ofthe neckline or the return move back to the neckline "again, At a top, once the neckline has been broken on the down- side, any decisive close back above the neckline isa serious warn- ing that the initial breakdown was probably a bad signal, and cre- ates what is often called, for obvious reasons, faled head and shoulders" "This type of pattern starts out looking like a classic head and shoulders reversal, but at some point in its development (cither prior to the breaking of the neckline or just after it), prices resume their original trend" ‘There are two important lessons here The first is that none of these chart patterns are infallible "They work most of the time, but not always" The second lesson is that technical traders must always be on the alert for chart signs that their analysis is incor- rect One of the keys to survival in the financial markets Is to keep trading losses small and to exit a losing trade as quickly as possi- ble One of the greatest advantages of chart analysis Is its ability Mejor Reversal Potts ns to quickly alert the trader to the fact that he or she is on the ‘wrong side of the market The ability and willingness to quickly recognize trading errors and to take defensive action immediately are qualities not to be taken lightly in the financial markets "‘The Head And Shoulders as a Consolidation Pattern Before moving on to the next price pattern, there's one final point to be made on the head and shoulders" We started this discussion by listing it as the best known and most reliable of the major reversal patterns "You should be warned, however, that this for- ‘mation can, on occasion, act as a consolidation rather than a reversal pattern" "When this does happen, it’s the exception rather than the rule" "Well talk more about this in Chapter 6, ""Con- tinuation Patterns" ” TRIPLE TOPS AND BOTTOMS Most of the points covered in the treatment of the head and shoulders patter are also applicable to other types of reversal pat- terns (See Figures 5 4a-c ") The triple top or bottom, which is much rarer in occurrence, is just a slight variation of that pattern" The ‘main difference is that the three peaks or troughs in the triple top ‘or bottom are at about the same level (See Figure 5 4a ) Chartists ‘often disagree as to whether a reversal pattern isa head and shoul- drs or a triple top "The argument is academic, because both pat- ters imply the exact same thing" ‘The volume tends to decline with each successive peak at the top and should increase at the breakdown point The triple top is not complete until support levels along both of the inter- vening lows have been broken "Conversely, prices must close through the two intervening peaks at the bottom to complete a triple bottom" "(As an alternate strategy, the breaking of the nearest peak or trough can also be used as a reversal signal" ) Heavy upside volume on the completion of the bottom is also ‘essential wail Figure $4 A triple top Similar tothe head and shoulders except that all peaks are a the same level Each rally peak should be on lighter volume "The pattern is complete when both troughs have been broken on heavier volume, The measuring technique i the height ofthe pattem projected downward from the breakdown point" "Return moves back othe lower line are not unusual Figure $4b A triple bottom, Similar toa head and shoulders bottom ‘xcept that each low is atthe same level" A miror image of the triple top excep that volume is more important on the upside breakout fees ean ed ane igure 5 4¢ A tiple bottom reversal pattem Prices found support just below 12 dre times on thi chart before launching a major advance "The bottom formation on this weekly chart lasted two full years, thereby giving it ‘major significance" "‘The measuring implication is also similar to the head and shoulders, and is based on the height of the pattern" Prices will usually move a minimum distance from the breakout point at least equal to the height of the pattern "Once the breakout occurs, a return move to the breakout point Is not unusual, Because the tuiple top or bottom represents only a minor variation of the head and shoulders pattern, we won't say much more about it here" DOUBLE TOPS AND BOTTOMS ‘A much more common reversal pattern is the double top or bottom [Next to the head and shoulders it is the most frequently seen and the most easily recognized "(See Figures 5,52-e,) Figures 5" 5a and 18 hopters Figure 5 Sa Example ofa double tp This patter has two peaks (A and (Chat about the same level The pattem Is complete when the mldde tough at point B is broken on aciosing bass Volume is usually lighter on these ‘ond peak (C) and picks up on the breakdown (D) "A return move back to the Tower Tine 6 not unusual, The minimum measuring target i the height of the {op projected downward from the breakdown point" Figure 5 56 Example ofa double bottom A miror image ofthe double top Volume is more important on the upside breakout Returm moves back to ‘the breakout point are mere common at bottoms Figure 5 "5 _ Example ofa double botiom, Ths stock bounced sharply off the 68 level vice over a span of thee months" Note that the second bottom ‘was also an upside reversal day The breaking of resistance at 80 completed the bottom 5 5 show both the top and bottom variety "For obvious reasons, the top Is often referred to as an “M"" and the bottom as a “W" """ ‘The general characteristics of a double top are similar to that of the head and shoulders and triple top except that only two peaks appear instead of three" The volume pattern is similar as Is the ‘measuring rule In an uptrend (as shown in Figure $ "Sa), the market sets a new high at point A, usually on increased volume, and then {declines to point B on declining volume" "So far, everything 1s pro- ‘ceeding as expected in a normal uptrend, The next rally to point however, is unable to penetrate the previous peak at A on a closing basis and begins to fall back again" A potential double top hhas been set up "I use the word “potential” because, as is the case ‘with all reversal patterns, the reversal is not complete until the Figure $54 Example ofa double top" Sometimes the second peak doesn’t ‘git reach the fist peak as in this example "Ths two month double top sig- aed majr deine, The acta signal was the resting of support ner (see box)" previous support point at B is violated on a closing basis "Until that happens, prices could be in just a sideways consolidation phase, preparing for a resumption of the original uptrend, ‘The ideal top has two prominent peaks at about the same price level" Volume tends to be heavier during the first peak and lighter on the second A decisive close under the middle trough at point B on heavier volume completes the pattern and signals a reversal of trend to the downside A return move to the breakout point is not unusual prior to resumption of the downtrend ‘Measuring Technique for the Double Top ‘The measuring technique for the double top is the height of the Pattern projected from the breakdown point (the point where the {7D sa Coroner ‘mira —— Figure 6 5 Price patters show up regularly on the chars of major stock ‘averages "On this chart, the Nasdaq Composite Index formed a double bot" tom near the 1470 level before tuning higher The break ofthe down trend- line (se box) confirmed the upturn ‘middie trough at point Bis broken) "As an alternative, measure the height of the first downleg (points A to B) and project that length ‘downward from the middle trough at point B" "Measurements at the bottom are the same, but in the other direction" "VARIATIONS FROM THE IDEAL PATTERN [As in most other areas of market analysis, real-life examples are ""usually some variation of the ideal" "For one thing, sometimes the ‘two peaks are not at exactly the same price level" "On occasion, the second peak will not quite reach the level of the first peak, which {is not too problematical" What does cause some problems is when 122 Copter $ the second peak actually exceeds the first peak by a slight margin What at first may appear to be a valid upside breakout and ‘resumption of the uptrend may tum out to be part of the topping ‘process "To help resolve this dilemma, some of the filtering crite- nia already mentioned may come in handy" Filters ‘Most chartists require a close beyond a previous resistance peak instead of just an intraday penetration "Second, a price filter of some type might be used" One such example is a percentage pene- tration criterion (such as 1% or 39) "Third, the two day penetration rule could be used as an example of a time filter" "In other words, prices would have to close beyond the top of the first peak for two Consecutive days to signal a valid penetration" Another time filter could be a Friday close beyond the previous peak "The volume on the upside breakout might also provide a clue to its reliability These filters are certainly not infallible, but do serve to reduce the number of false signals (or whipsaws) that often occur" "Sometimes these filters are helpful, and sometimes they're not" "‘The analyst must face the realization that he or she is dealing with, percentages and probabilities, and that there will be times when bbad signals occur" That's simply a fact of trading life It’s not that unusual for the final leg or wave of a bull m ket to set a new high before reversing direction "In such a case, the final upside breakout would become a “bull trap" ” (See Figures 5 6a and b ) We'll show you some indicators later on that may help you spot these false breakouts ‘The Term “Double Top” Greatly Overused ‘The terms “double top and bottom” are greatly overused In the financial markets Most potential double tops or bottoms wind up being something else The reason for this is that prices have a strong tendency to back off from a previous peak or bounce off a previous low These price changes are a natural reaction and do not in themselves constitute a reversal pattern "Remember that, at ‘top, prices must actually violate the previous reaction low before the double top exists" re 5 68 ‘Example ofa false ‘ous time and price Era _ einen PLE a) pes Ys 1 1 fault \ yt i : fy 7 ul sila Figure 6 66 Example of false breakout Notice thatthe upside breakout ‘was on light volume and the subsequent decline on heavy volume—a nega tive chat combination "Watching the volume helps avoid some false break- ‘outs, but not al 124 Choper$ Notice in Figure $" 7a that the price at point C backs off from the previous peak at point A This is perfectly normal action Inne e570 Eurple of normal gure 87 umpicofenae falta fm ap sma bance prvi le "Ts panne only curs when support at wat ast ene cash ference ‘point Bis broke, ‘alls fora double bet" "Major Revers Patens 125 ‘Time Between Peaks or Troughs Js Important Finally, the siz of the pattern is always important" The longer the time period between the two peaks and the greater the height of "the pattern, the greater the potential impending reversal" This is true of all chart patterns "In general, most valid double tops or bottoms should have at least a month between the two peaks or troughs, Some will even be two or three months apart" "(On longer range monthly and weekly charts, these patterns can span sever- al years" ) Most of the examples used in this discussion have described market tops "The reader should be aware by now that bottoming patterns are mirror images of tops except for some of, the general differences already touched upon at the beginning of the chapter" "SAUCERS AND SPIKES Although not seen as frequently, reversal patterns sometimes take ‘the shape of saucers or rounding bottoms" The saucer bottom shows a very slow and very gradual turn from down to sideways ‘to up It is difficult to tell exactly when the saucer has been com- pleted or to measure how far prices will travel in the opposite direction Saucer bottoms are usually spotted on weekly or monthly charts that span several years "The longer they last, the more significant they become" (See Figure 5 8 ) ‘Spikes are the hardest market turns to deal with because the spike (or V pattern) happens very quickly with little or no transi- ton period "They usually take place in a market that has gotten so overextended in one direction, that a sudden piece of adverse news causes the market to reverse direction very abruptly" "A daily or weekly reversal, on very heavy volume, is sometimes the only warning they give us" "That being the case, there's not much more wwe can say about them except that we hope you don’t run into too many of them" Some technical indicators we discuss in later chapters will help you determine when markets have gotten dan- gerously over-extended (See Figure 5 9 ) Figure $ 8 This chart shows what a saucer (or rounding) bottom Tooks like "They're very slow and gradual, but usually mark major turns" This bot- tom astd four yeas Figure 5 9 Example ofa v reversal patter These sudden reversals take place with litle or no warning A sudden price drop on heavy volume is usu filly the ony telltale sgn "Unfortunately, these sudden turns are hard 0 spot in advance, 128 haper$ CONCLUSION We've discussed the five most commonly used major reversal pat- {ems the head and shoulders, double and triple tops and bot" "toms, the saucer, and the V, or spike" "Of those, the most common, are the head and shoulders, and double tops and bottoms" These patterns usually signal important trend reversals in progress and are classified as major reversal patterns "There is another class of pattems, however, which are shorter term in nature and usually Suggest trend consolidations rather than reversals" They are aptly {jlled continuation patterns "Lets look at this other type of pattern in Chapter 6, Continuation Patterns ho Ee ne HD INTRODUCTION ‘The chart patterns covered in this chapter are called continuation patterns" "These patterns usually indicate that the sideways price action on the chart is nothing more than a pause in the prevall- ing trend, and that the next move will be in the same direction as the trend that preceded the formation" "This distinguishes this ‘group of patterns from those in the previous chapter, which usu- ally indicate that a major trend reversal isin progress" ‘Another difference between reversal and continuation pattems is their time duration "Reversal patterns usually take much longer to bulld and represent major trend changes, Continuation patterns, on the other hand, are usually shorter term in duration and are more accurately classified as near term or intermediate patterns" Notice the constant use of the term “usually ” The treat ‘ment of all chart patterns deals of necessity with general tenden- ies as opposed to rigid rules There are always exceptions Even the grouping of price patterns into different categories sometimes 129 130 Oropter becomes tenuous "Triangles are usually continuation patterns, but sometimes act as reversal patterns" "Although triangles are usually Considered intermediate patterns, they may occasionally appear fon Jong term charts and take on major trend significance" A vari- ation of the triangle—the inverted variety—usually signals a ‘major market top "Even the head and shoulders pattern, the best known of the major reversal patterns, will on occasion be seen as @ consolidation pattern" "Even with allowances for a certain amount of ambiguity and the occasional exception, chart patterns do generally fall into the above two categories and, if properly interpreted, can help the chartist determine what the market will probably do ‘most of the time TRIANGLES Let's begin our treatment of continuation patterns with the tri dangle" "There are three types of trlangles—symmetrical, ascend ing, and descending" "(Some chartists include a fourth type of tr- angle known as an expanding triangle, or broadening formation" ‘This is treated as a separate pattern later Each type of triangle has a slightly different shape and has different forecasting implications Figures 6 la-c show examples of what each triangle looks like The symmetrical triangle (see Figure 6 "1a) shows ‘two converging trendlines, the upper line descending and the lower line ascending" "The vertical line at the left, measuring" "the height of the pattern, Is called the base, The point of inter section at the right, where the two lines meet, is called the apex" "For obvious reasons, the symmetrical triangle is also called a coil ‘The ascending triangle has a rising lower line with a flat or horizontal upper line (see Figure 6" 1b) The descending tri- angle (Figure 6 "1¢), by contrast, has the upper line declining with a flat or horizontal bottom line" Let's see how each one is interpreted Continuation Potters 131 Figure 6 "18 Example ofa bullish symmetrical trlangle, Notice the two ‘converging trendline" close ouside ether trendline completes the patter ‘The vertical line at the lef i the base The point a the right where the two Tines meet i the apex Figure 6 1 Example of an ascending triangle Notice the flat upper line ‘and the rising lower line "This 1 generally a bullish patter, 132 hopter6 Figure 6" 1e Example of a descending tangle Notice the flat bottom Tine ‘andthe declining upper line This is usually a bearish pater THE SYMMETRICAL TRIANGLE ‘The symmetrical triangle (or the coil) is usually a continuation Pattern It represents 2 pause in the existing trend after which the original trend is resumed In the example in Figure 6 "a, the prior trend was up, so that the percentages favor resolution of the triangular consolidation on the upside" "If the trend had been down, then the symmetrical triangle would have bearish Implications" ‘The minimum requirement for a triangle is four reversal points Remember that it always takes two points to draw a trendline "Therefore, in order to draw two converging trendlines, each line must be touched at least twice" In Figure 6 "la, the tri- angle actually begins at point 1, which is where the consolida- ton in the uptrend begins" Prices pull back to point 2 and then rally to point 3 "Point 3, however, is lower than point 1" The upper trendline can only be drawn once prices have declined from point 3 Notice that point 4 is higher than point 2 "Only when prices have rallied from point 4 can the lower upslanting line be Grawn, Its at this point that the analyst begins to suspect the he (or she Is dealing with the symmetrical triangle" "Now there are four reversal points (1, 2, 3, and 4) and two converging trendlines" "‘While the minimum requirement is four reversal points, ‘many triangles have six reversal points as shown in Figure 6" "1a, Comtinsian Potters 133 ‘This means that there are actually three peaks and three troughs that combine to form five waves within the triangle before the uptrend resumes" "(When we get to the Elliott Wave Theory, we'll hhave more to say about the five wave tendency within triangles" ") ‘Time Limit for Triangle Resolution ‘There is a time limit for the resolution of the pattern, and that is" the point where the two lines meet—at the apex "Asa general rule, prices should break out in the direction of the prior trend some- where between two-thirds to three-quarters of the horizontal width of the triangle" "That is, the distance from the vertical base ‘on the left of the pattern to the apex at the far right" "Because the ‘two lines must meet at some point, that time distance can be mea- sured once the two converging lines are drawn" An upside break- ‘out is signaled by a penetration of the upper trendline "If prices remain within the triangle beyond the three-quarters point, the triangle begins to lose its potency, and usually means that prices will continue to drift out to the apex and beyond ‘The trlangle, therefore, provides an interesting combina- ton of price and time" "The converging trendlines give the price boundaries of the pattern, and indicate at what point the pattern thas been completed and the trend resumed by the penetration of the upper trendline (in the case of an uptrend)" But these trend- lines also provide a time target by measuring the width of the pat- tern "Ifthe width, for example, were 20 weeks long, then the break ‘out should take place sometime between the 13th and the 15th week" (See Figure 6 14 ) ‘The actual trend signal is given by a closing penetration of one of the trendlines Sometimes a return move will occur back to the penetrated trendline after the breakout "In an uptrend, that line has become a support line" "In a downtrend, the lower line ‘becomes a resistance line once it’s broken, The apex also acts as an Important support or resistance level after the breakout occurs" "Various penetration criteria can be applied to the breakout, simi lar to those covered in the previous two chapters" "A minimum penetration criterion would be a closing price outside the trend- line and not just an intraday penetration, Figure 6" 14 Dell formed « bullish symmetrical triangle during the fourth ‘quarter of 1997 "Measured ftom lft to right, the tiangle width is 18 weak" "Prices broke out onthe 1301 weok (ee cre, just beyond the two-thirds point Importance of Volume Volume should diminish as the price swings narrow within the triangle" This tendency for volume to contract is true of all con- solidation patterns But the volume should pick up noticeably at the penetration of the trendline that completes the pattern The retum move should be on light volume with heavier activity again as the trend resumes ‘Two other points should be mentioned about volume "As is the case with reversal patterns, volume is more important on" the upside than on the downside An increase in volume is essen- {alto the resumption of an uptrend in all consolidation patterns "The second point about volume is that, even though trading activity diminishes during formation of the pattern, a close inspection of the volume usually gives a clue as to whether ContinatonPatens 135 the heavier volume is occurring during the upmoves or down- moves" "In an uptrend, for example, there should be a slight ten- dency for volume to be heavier during the bounces and lighter ‘on the price dips" Measuring Technique Triangles have measuring techniques "In the case of the sym- metrical triangle, there are a couple of techniques generally used" The simplest technique is to measure the height of the vei tical line at the widest part of the triangle (the base) and me sure that distance from the breakout point Figure 6 "2 shows the distance projected from the breakout point, which Is the tech- nique I prefer" The second method is to draw a trendline from the top Of the base (at point A) parallel to the lower trendline "This upper channel line then becomes the upside target in an uptrend, It Is possible to arrive at a rough time target for prices to meet the upper channel line" Prices will sometimes hit the channel line at the same time the two converging lines meet at the apex Figure 6 "2 There ‘are two ways to take ‘measurement fom 4 symmetrical trian ‘le, One is 9 mea- Sure the height ofthe ‘base (AB); project ‘hat vertical dlstance ram the breakout point at C" Another ‘method i to draw a parallel line upward {rom the top of the baseline (A) parallel to the lower fine the triangle "136 Chapters THE ASCENDING TRIANGLE ‘The ascending and descending triangles are variations of the sym- ‘metrical, but have diferent forecasting implications" Figures 6 34 and b show examples of an ascending triangle "Notice that the upper trendline is flat, while the lower line is rising" This pattern Indicates that buyers are more aggressive than sellers It is consid- cred @ bullish pattern and is usually resolved with a breakout to the upside Both the ascending and descending triangles differ from the symmetrical in a very important sense "No matter where in the trend structure the ascending or descending triangles appear, they have very definite forecasting implications" The ascending ‘triangle is bullish and the descending triangle is bearish "The sym- ‘metrical triangle, by contrast, is inherently a neutral pattern, This does not mean, however, that the symmetrical triangle does not hhave forecasting value" "On the contrary, because the symmetrical Figure 6" 30 An ascending langle The pattem is completed on a deh sve close above the upper line This breakout should se a sharp increase in ‘volume That upper resistance line should act as support on subsequent dips “after the breakout The minimum price objective is obtained by measuring ‘the height ofthe triangle (AB) and projecting that distance upward from the breakout point at C — = Figure 6 36 The Dow Transports formed a bullish ascending triangle near ‘the end of 1997 Notice the flat upper line at 3400 and the rising lower line This is normally a bullsh pattem no mater where it appears on the chart "trlangle is a continuation pattern, the analyst must simply look to see the direction of the previous trend and then make the assump- tion that the previous trend will continue" Let's get back to the ascending triangle "As already stated, more often than not, the ascending triangle Is bulish" The bullish breakout is signaled by a decisive closing above the flat upper trendline "As in the case of all valid upside breakouts, volume should see a noticeable increase on the breakout" A return move back to the support line (the flat upper line) is not unusual and should take place on light volume Measuring Technique ‘The measuring technique for the ascending triangle is relatively "simple, Simply measure the height of the pattern at its widest 138 Chapters point and project that vertical distance from the breakout point" ‘This is just another example of using the volatility of a price pat- tem to determine a minimum price objective "‘The Ascending Triangle as a Bottom While the ascending triangle most often appears in an uptrend, and is considered a continuation pattern, it sometimes appears as ' bottoming patter, It is not unusual toward the end of a down- trend to see an ascending triangle develop" "However, even in t situation, the interpretation of the pattern is bullish" The break- ing of the upper line signals completion of the base and is con- sidered a bullish signal Both the ascending and descending trian Bles are sometimes also referred to as right angle triangles "‘THE DESCENDING TRIANGLE ‘The descending triangles just a mirror image of the ascending, and is generally considered a bearish pattern" Notice in Figures 6 43 and b the descending upper line and the flat lower line "This pat- tern indicates that sellers are more aggressive than buyers, and is usually resolved on the downside, The downside signal is regis tered by a decisive close under the lower trendline, usually on Increased volume" "A return move sometimes occurs which should ‘encounter resistance at the lower trendline, ‘The measuring technique is exactly the same as the ascending triangle in the sense that the analyst must measure the height of the pattern at the base to the left and then project that distance down from the breakdown point" "‘The Descending Triangle as a Top ‘While the descending triangle is a continuation pattern and usu- ally is found within downtrends, itis not unusual on occasion for the descending triangle to be found at market tops" This type of pattern is not that difficult to recognize when it does appear in the top setting "In that case, a close below the flat lower line would sig- ‘nal a major trend reversal to the downside 139 Continuation Ptr Figure 64a 4 descending tian: ‘le" The bearish patter complet pe DOO Figure 6 4b A bearish descending triangle formed in Du Pont during the autumn of 1997 The upper line 1s descending while the lower line is Fat "The break of the lower line in early October resolved the patter t0 the ‘downside, 140 hpter 6 ‘The Volume Pattern ‘The volume pattern in both the ascending and descending trian- gles is very similar in that the volume diminishes as the pattern ‘works itself out and then increases on the breakout" "As in the case of the symmetrical triangle, during the formation the chartist can detect subtle shifts in the volume pattern coinciding with the swings in the price action" "This means that in the ascending pat- tem, the volume tends to be slightly heavier on bounces and lighter on dips" "In the descending formation, volume should be heavier on the downside and lighter during the bounces" ‘The Time Factor in Triangles ‘One final factor to be considered on the subject of triangles is that of the time dimension "The triangle is considered an intermediate pattern, meaning that it usually takes longer than a month to form, but generally less than three months" "A triangle that lasts less than a month is probably a different pattern, such as a pen- nant, which will be covered shortly" "As mentioned earlier, trian- ‘gles Sometimes appear on long term price charts, but thelr basic ‘meaning is always the same" "THE BROADENING FORMATION ‘This next price patter is an unusual variation ofthe triangle and {s relatively rare, Its actually an Inverted triangle ora triangle turned backwards" All ofthe triangular pattems examined s0 far show converging trendlines "‘The broadening formation, as the name implies, Is just the opposite" As the pattern in Figure 6 "5 shows, the tendlines actually diverge in the broadening forma- tion, creating a picture that looks like an expanding triangle" It also called a megaphone top "‘The volume patter also differs in this formation, In the ‘other triangular pattems, volume tends to diminish asthe price swings grow narrower" Just the opposite happens in the broaden- ing formation The volome tends to expand along with the wider price swings This situation represents a market that fs out of control Continuation Patterns 141 Figure 6 5 A broadening tp "This type of expanding triangle usualy ccturs at major tops, It shows thre sucesively higher peaks and two deli lng troughs" The violation ofthe second ough completes the pattern This is fan unusually dificult pattern to trade and fortunately is relatively rare and unusually emotional "Because this pattern also represents an ‘unusual amount of public participation, it most often occurs at ‘major market tops" "The expanding pattern, therefore, is usually a bearish formation, t generally appears near the end of a major bull market" "FLAGS AND PENNANTS “The flag and pennant formations are quite common, They are ust- ally treated together because they are very similar in appearance, tend to show up at about the same place in an existing trend, and hhave the same volume and measuring criteria" ‘The flag and pennant represent brief pauses in a dynamic ‘market move "In fact, one of the requirements for both the flag" "142 Copter and the pennant is that they be preceded by a sharp and almost straight line move, They represent situations where a" "steep advance or decline has gotten ahead of itself, and where the mar, ket pauses briefly to “catch its breath” before running off again in the same direction, Flags and pennants are among the most reliable of conti vation pattems and only rarely produce a trend reversal" Figutes 6 6a-b show what these two patterns look like "To begin with, notice the steep price advance preceding the formations on heavy Volume" Notice also the dramatic drop off in activity as the com solidation patterns form and then the sudden burst of activity on the upside breakout Construction of Flags and Pennants ‘The construction of the two pattems differs slightly The flag ‘esembles a parallelogram or rectangle marked by two parallel rendlines that tend to slope against the prevailing trend "In a downtrend, the flag would have a slight upward slope" Fare 60am ata ee ee Foe cea SSemeh armas rea ae J | eet borhan ee ae orice ete Prien ramets Continuation Pers 143 Figure 6 60 A bullish ‘perant "Resembles a Small symmetrical tian- fle, but usually lasts no longer than three wees" Volume should be light during its formation The ‘move after the pennant is ‘completed should dupl- ‘ate the sizeof the move preceding it ‘The pennant is identified by two converging trendlines and is more horizontal It very closely resembles a small symmet- ical triangle An Important requirement is that volume should ‘dry up noticeably while each of the patterns is forming ‘Both patterns are relatively short term and should be com- pleted within one to three weeks "Pennants and flags in down- trends tend to take even Jess time to develop, and often last no longer than one or two weeks" Both pattems are completed on the penetration of the upper trendline in an uptrend The breaking of the lower trendline would signal resumption of downtrends The breaking of those trendlines should take place on heavier volume "‘As usual, upside volume is more critically important than down- side volume" (See Figures 6 7a-b ) Measuring Implications ‘The measuring Implications are similar for both patterns Flags land pennants are said to “fly at half-mast” from a flagpole The flagpole is the prior sharp advance or decline The term “half- mast” suggests that these minor continuation patterns tend to Figure 6 "7a A bullish lag in Intemational Paper, The flag loks Tike a ‘down-sloping parallelogram" Notice thatthe flag acumed right atthe /halfay pont of the uptrend appear at about the halfway point of the move "In general, the ‘move after the trend has resumed will duplicate the flagpole or the move just prior to the formation of the pattern ‘To be more precise, measure the distance of the preceding ‘move from the original breakout point" "That is to say, the point at which the original trend signal was given, elther by the penet tion of a support or resistance level or an important trendline" "‘That vertical distance of the preceding move is then measured from the breakout point of the flag or pennant—that is, the point at which the upper line Is broken in an uptrend or the lower line in a downtrend" "Summary Let's summarize the more important points of both patterns, Coninuatin Potters 145 = a a ed Figure 6" 7 A couple of ponnants are flying on this Caterpillar chart ‘Pennants are short term continuation pattems that lok like smal symeti- ‘al triangles "The pennant tothe left continued the uptrend, while the one to ‘the right continued the downtrend" "1, They are both preceded by an almost straight line move (called a flagpole) on heavy volume" "2, Prices then pause for about one to three weeks on very light volume" "3, The trend resumes on a burst of trading activity 4" Both patterns occur at about the midpoint of the market move "5, The pennant resembles a small horizontal symmetrical tr- Helogram that slopes against 7" Both patterns take less time to develop in downtrends | Both patterns are very common in the financial markets 146 Chapter THE WEDGE FORMATION ‘The wedge formation {s similar to a symmetrical triangle both in terms of its shape and the amount of time it takes to form "Like the symmetrical triangle, itis identified by two converging trend lines that come together at an apex" "In terms of the amount of time it takes to form, the wedge usually lasts more than one ‘month but not more than three months, putting it into the inter- mediate category" ‘What distinguishes the wedge is its noticeable slant The wedge pattern has a noticeable slant elther to the upside or the downside "As a rule, like the flag pattern, the wedge slants against the prevailing trend" "Therefore, a falling wedge ls considered bullish sand a rising wedge is bearish" Notice in Figure 6 8a that the bullish wedge slants downward between two converging trendlines In the downtrend in Figure 6 "8b, the converging trendlines have an Uunmistakable upward slant" "re a Eionple of lsh fang wedge, The Continuation Patterns 147 Figure 6" 8 Example ofa bearish wedge A bearish ‘wedge should slope ‘upward against the prevailing down trend ‘Wedges as Tops and Bottom Reversal Patterns Wedges show up most often within the existing trend and usually constitute continuation patterns "The wedge can appear at tops or bottoms and signal a trend reversal, But that type of situation is ‘much less common" "Near the end of an uptrend, the chartist may" observe a clearcut rising wedge "Because a continuation wedge in {an uptrend should slope downward against the prevailing trend, the rising wedge isa clue to the chartist that this is a bearish and not a bullish pattern" "At bottoms, a falling wedge would be a tip- off of a possible end of a bear trend, ‘Whether the wedge appears in the middle or the end of a market move, the market analyst should always be guided by the ‘general maxim that a rising wedge is bearish and a falling wedge is bullish" (See Figure 6 8c ") ‘THE RECTANGLE FORMATION ‘The rectangle formation often goes by other names, but is usually easy to spot on a price chart" It represents a pause in the trend dur- {ng which prices move sideways between two parallel horizontal lines (See Figures 6 9a-c ) The rectangle is sometimes referred to as a trading range or ‘a congestion area "In Dow Theory parlance, its referred to as a line" "Whatever it 1s called, It usually represents just a consolidation period in the existing trend, and is usually resolved in the direc- FS) cmmenonme Paty er chat ‘Commer Retewch Bray ne Geant AengWedoe Figure 6" 86 Example ofa bearish ising wedge The two converging vend lines have a definite upward slant The wedge slants against the prevailing trend "Therefore a rising wede is bearish, and a falling wedge is bullish, Figure 6" 98 Example of @ bull ish rectangle in an uptrend "This pat- tem Is also called «trading range, ‘and shows prices trading between ‘0 horizontal trendlines" "Is also called a con- Sestion area, Contivaton Potters 149 Figure 6" 96 Example oft bearish rectangle "While rectangles are usu- ally considered continua thon pater, the trader ‘mast always bear for ‘sigs that It may’ tum Into a rversal pattem" "LJ sic asa rite bot, ras ee cone Conn oF oP c PM apy E in ——— Figure 6" 9¢ _A bullish rectangle Compa’ uptrend was interupted for four montis while it traded sideways The break above the upper line in early May completed the patter and resumed the uptrend Rectangles are usually continuation patterns 150 Copter tion of the market trend that preceded its occurrence "In terms of forecasting value, it can be viewed as being similar to the sym- ‘metrical triangle but with flat instead of converging trendline: AA decisive close outside elther the upper or lower bound- ary signals completion of the rectangle and points the direction of the trend" "The market analyst must always be on the alert, how- ever, that the rectangular consolidation does not turn into a rever- sal pattern" In the uptrend shown in Figure 6 "93, for example, notice that the thee peaks might initially be viewed as a possible triple top reversal pattern, ‘The Importance of the Volume Pattern One important clue to watch for is the volume pattern, Because the price swings in both directions are fairly broad, the analyst ‘should keep a close eye on which moves have the heavier volume" "Uf the rallies are on heavier and the setbacks on lighter volume, then the formation is probably a continuation in the uptrend" "If the heavier volume is on the downside, then it can be considered warning of a possible trend reversal in the works" "‘Swings Within the Range Can Be Traded Some chartists trade the swings within such a pattern by buying {dips near the bottom and selling rallies near the top of the range, ‘This technique enables the short term trader to take advantage of the well defined price boundaries, and profit from an otherwise trendless market" "Because the positions are being taken at the extremes of the range, the risks ate relatively small and well defined" "If the trading’ range remains intact, this countertrend trading approach works quite well" "When a breakout does occur, the trader not only exits the last losing trade immediately, but can reverse the previous position by initiating a new trade in the direction of the new trend" "Oscillators are especially useful in side Ways trading markets, but less useful once the breakout has ‘occurred for reasons discussed in Chapter 10" "Other traders assume the rectangle Is a continuation pat tern and take long positions near the lower end of the price band Continuotion Pater 151 in an uptrend, of initiate short positions near the top of the range in downtrends, Others avoid such trendless markets altogether ‘and await a clearcut breakout before committing their funds" "Most trend-following systems perform very poorly during these periods of sideways and trendless market action, Other Similarities and Differences In terms of duration, the rectangle usually falls into the one to three month category, similar to triangles and wedges" The vol- ‘ume pattern differs from other continuation patterns in the sense that the broad price swings prevent the usual dropoff in activity seen in other such patterns ‘The most common measuring technique applied to the rectangle is based on the height of the price range "Measure the height of the trading range, from top to bottom, and then project that vertical distance from the breakout point" "This method is similar to the other vertical measuring techniques already men- tioned, and is based on the volatility of the market" "When we cover the count in point and figure charting, we'll say more on" the question of horizontal price measurements Everything mentioned so far concerning volume on break- ‘outs and the probability of return moves applies here as well "Because the upper and lower boundaries are horizontal and so well defined in the rectangle, support and resistance levels are ‘more clearly evident" "This means that, on upside breakouts, the top of the former price band should now provide solid support on any selloffs" "After a downside breakout in downtrends, the bot- ‘tom of the trading range (the previous support area) should now provide a solid ceiling over the market on any rally attempts" "‘THE MEASURED MOVE “The measured move, ot the swing measurement as itis sometimes called, describes the phenomenon where a major market advance fr decline is divided into two equal and parallel moves, as shown in Figure 6,10a, For this approach to work, the market moves Figure 6" 10 Example ofa measired ‘move (tthe swing mea Sweet) nan Ts theory ats hatte second leg in the advance (CD) duplicates the size and slope of he fst ples (AB) The conectve ‘ne (BC) often reraces third wa half of AB beret pred a he Figure 6 "10b A measured move takes the prior upleg (AB) and ads that ‘value tothe bottom of the correction tC, On this chat the prior uptrend (AB) was 20 points" Adding that tothe lowpoint at C (62) yielded a price target to 82 (D) ontruotion Pater 153 should be fairly orderly and well defined The measured move is really just a variation of some of the techniques we've already touched on "We've seen that some of the consolidation patterns, Such as flags and pennants, usually oceur at about the halfway" "point of a market move, We've also mentioned the tendency of Inarkets to retrace about a third to a half of a prior trend before resuming that trend" "im the measured move, when the chartist sees a well defined situation, such asin Figure 6" "10a, with a rally from point ‘A to point B followed by a countertrend swing from point B to point C (which retraces a third to a half of wave AB), it is {assumed that the next leg in the uptrend (CD) will come close to ‘duplicating the fist leg (AB)" "The height of wave (AB), therefore, is imply measured upward from the bottom of the correction at point C" "THE CONTINUATION HEAD AND SHOULDERS PATTERN In the previous chapter, we treated the head and shoulders pat- tem at some length and described it as the best known and most trustworthy of all reversal patterns" The head and shoulders pat- tern can sometimes appear as a continuation instead of a reversal pattern "In the continuation head and shoulders variety, prices" ce out a pattern that looks very similar to a sideways rectangu- lar pattern except that the middle trough in an uptrend (see Figure 6 1 1a) tends to be lower than either of the two shoulders Ina downtrend (see Figure 6 "11b), the middle peak in the consol- {dation exceeds the other two peaks" The result in both cases is 8 hhead and shoulders pattern turned upside down "Because it is ‘tumed upside down, there Is no chance of confusing it with the reversal pattern" 154 Copter Figure 6 118 Example of« bullish continuation head and shoulders pattern Figure 6 11b Example ofa bearish continuation head and shoulders paters OE aoe Figure 6 11¢ | General Motors formed a continuation head and shoulders pattern daring the frst half of 1997 The pattern i very clear but shows up {man urasual place The patter was completed and the uptrend resumed with the clase above the neckline at 60 CONFIRMATION AND DIVERGENCE "‘The prineiple of confirmation is one of the common themes run~ ning throughout the entire subject of market analysis, and is used Jn conjunction with its counterpart—divergence" "We'll introduce oth concepts here and explain their meaning, but we'll return to them again and again throughout the book because their impact is so important" "We're discussing confirmation here in the context of chart patterns, but it applies to virtually every aspect of technical ‘analysis" Confirmation refers to the comparison of all technical sig- nals and indicators to ensure that most of those indicators are ‘pointing in the same direction and are confirming one another 156 Chapter 6 Divergence is the opposite of confirmation and refers to a situation where different technical indicators fall to confirm one another "White it is being used here in a negative sense, diver- ence is a valuable concept in market analysis, and one of the best early warning signals of impending trend reversals, We'll discuss the principle of divergence at greater length in Chapter 10, “Oscillators and Contrary Opinion" "” CONCLUSION ‘This concludes our treatment of price patterns, We stated earlier that the three pieces of raw data used by the technical analyst ‘were price, volume, and open interest" Most of what we've said so fat hhas focused on price Let’s take a closer look now at volume and ‘open interest and how they are incorporated into the analytical process "Volume and Open Interest INTRODUCTION Most technicians in the financial markets use a multidimension- ‘al approach to market analysis by tracking the movement of three Sets of figures—price, volume, and open interest" Volume analysis Applies to all markets Open interest applies primarily to futures ‘markets Chapter 3 discussed the construction of the daily bar Chart and showed how the three figures were plotted on that type Of chart "It was stated then that even though volume and open Interest figures are available for each delivery month in futures ‘markets, the fotal figures are the ones generally used for forecast- ing purposes" Stock chartists simply plot total volume along with the accompanying price “Most of the discussion of charting theory to this point has concentrated mainly on price action with some mention of vol- time "In this chapter, well round out the three dimensional approach by taking a closer look atthe role played by volume and ‘Open interest in the forecasting process 187 158 Chapter? VOLUME AND OPEN INTEREST AS SECONDARY INDICATORS Let's begin by placing volume and open interest in their proper Perspective" "Price is by far the most important, Volume and open interest are secondary in importance and are used primarily as con- firming indicators" "Of those two, volume is the more important" Volume Volume is the number of entities traded during the time period under study "Because we'll be dealing primarily with daily bar charts, our main concern is with daily volume" "That daily volume is plotted by a vertical bar at the bottom of the chart under the ‘day's price action, (See Figure 7" 1 ") ayer, 2 Figure 7" 1 Notice that the volume bars are noticeably lager as prices are rallying (se circles) "That means tht volume is confirming the pice rise and is bullish Volume ond Open interest, 159 ‘Volume can be plotted for weekly bar charts as well" "In that case, total volume for the week would simply be plotted under the bar representing that week's price action" "Volume is usually not ‘used, however, on monthly bar charts" Open Interest in Futures “The total number of outstanding or unliquidated contracts at the end of the day is open interest In Figure 7 "2, open interest is the solid line plotted on the chart under its corresponding price data for the day, but above the volume bars" "Remember that official volume and open interest figures are reported a day late in the futures markets and are, therefore, plotted with a one day lag" (Only estimated volume figures are available for the last trading day ") That means that each day the chartist plots the high, low, fand closing price bar for the last day of trading, but plots the offi- Gal volume and open interest figures for the previous day" "‘Open interest represents the total number of outstanding longs or shorts in the market, not the sum of Both" Open interest is the number of contracts "A contract must have both a buyer and a seller, Therefore, two market participants—a buyer and a seller— Combine to cteate only one contract" "The open interest figure Feported each day is followed by either a positive or negative ‘number showing the increase or decrease in the number of con- tracts for that day, Its those changes in the open interest levels, either up or down, that give the chartist clues as to the changing ‘character of market participation and give open interest Its fore- casting value" How Changes in Open Interest Occur "In order to grasp the signifi- ‘cance of how changes in the open interest numbers are interpret- fed, the reader must first understand how each trade produces a change in those numbers" "‘Every time a trade is completed on the floor of the exchange, the open interest {s affected in one of three ways—it Increases, decreases, of stays unchanged" Let’s see how those ‘changes occur 160 hepter7 Change in Buyer Seber Open interest 1 Buys new long Seis new short Increases 2 Buys new long Sel ld long No change 3 Buys old short Sells new short No change 4 "Buys ld short Sel od long Decreases In the first case, both the buyer and seller are initiating a new position and a new contract Is established" "In case 2, the Duyer is initiating a new long position, but the seller is merely iq" "uuldating an old long, One is entering and the other exiting ‘rade" The result is a standoff and no change takes place in the ‘number of contracts "In case 3, the same thing happens except this time it is the seller who is initiating a new short and the buyer who is only covering an old short" "Because one of the traders is centering and the other exiting a trade, again no change Is pro- duced" "In case 4, both traders are liquidating an old position and" the open interest decreases accordingly "‘To sum up, if both participants in a trade are initiating a ‘new position, the open interest will increase" If both are liquidat "Jing an old position, the open interest will decline" "If, however, ‘one is initiating a new trade while the other is liquidating an old, trade, open interest will remain unchanged" "By looking at the net change in the total open interest at the end of the day, the chartist is able to determine whether money is flowing into or out of the market" This information enables the analyst to draw some con ally a zero line" Some oscillators also have upper and lower bound- aries ranging from 0 to 100 "General Rules for Interpretation ‘Asa general rule, when the oscillator reaches an extreme value in" "‘either the upper or lower end of the band, this suggests that the ‘current price move may have gone too far too fast and is due for 4 correction or consolidation of some type" "As another general rule, the trader should be buying when the oscillator line is in the lower end of the band and selling in the upper end" The crossing Of the midpoint line is often used to generate buy and sell signals We'll see how these general rules are applied as we deal with the various types of oscillators ‘The Three Most Important Uses for the Oscillator ‘There are three situations when the oscillator is most useful You'll see that these three situations are common to most types of ‘oscillators that are used 1 The oscillator is most useful when its value reaches an extreme reading near the upper or lower end of its bound aries The market is said to be overbought when itis near the ‘upper extreme and oversold when It Js near the lower extreme This warns that the price trend is overextended and vulnerable 2 A divergence between the oscillator and the price action When the oscillator is in an extreme position is usually an important warning 3 The crossing of the zero (or midpoint) line can give impor tant trading signals in the direction of the price trend 12 ay omer oat Figure 10 "18 The 10 day momentum line fluctuates around a zero line Readings too far above the 2ro line are overbought, while values too far below the line are oversold" Momentum should be used in conjunction with ‘the rend ofthe market MEASURING MOMENTUM ‘The concept of momentum is the most basic application of oscilla- tor analysis Momentum measures the velocity of price changes as ‘opposed to the actual price levels themselves Market momentum {is measured by continually taking price differences for a fixed time interval "To construct a 10 day momentum line, simply sub- tract the closing price 10 days ago from the last closing price" This positive or negative value is then plotted around a zeto line The formula for momentum is: M=V-ve where V is the latest closing price and V* is the closing price x days ago scot and Centro Opinion 229 a eae aaa wot = aoa te A Figure 10 1b A comparison of 10 and 40 day momentum lines The longer version is more helpful in catching major market tums (se circles) "If the latest closing price is greater than that of 10 days ago {in other words, prices have moved higher), then a positive value ‘would be plotted above the zero line" "If the latest close is below the close 10 days earlier (prices have declined), then a negative value is plotted below the zero line" "‘While the 10 day momentum is a commonly used time period for reasons discussed later, any time period can be employed" (See Figure 10 la ) A shorter time period (such as 5 days) produces a more sensitive line with more pronounced osc lations A longer number of days (such as 40 days) results in a much smoother line in which the oscillator swings are less volatile (See Figure 10 1b ) 230 Chapter 10 Lets talk abit more about just what this momentum indicator is measuring "By plotting price differences for a set period of time, the charts is studying rates of ascent or descent" "If prices are ris ing and the momentum line is above the zero line and rising, this ‘means the uptrend is accelerating" "If the up-slanting momentum line begins to flatten out, this means that the new gains being achieved by the latest closes are the same as the gains 10 days ear= lies" "While prices may still be advancing, the rate of ascent (or the velocity) has leveled off" "When the momentum line begins to drop toward the zero line, the uptrend In price is still in force, but ata decelerating rate, The uptrend is losing momentum" "‘When the momentum line moves below the zero line, the latest 10 day close is now under the close of 10 days ago and a near term downtrend isin effect" "(And, incidentally, the 10 day moving average also has begun to decline) As momentum con: tinues to drop farther below the zero line, the downtrend gains ‘momentum, Only when the line begins to advance again does the analyst know that the downtrend is decelerating" Tt important to remember that momentum measures the differences between prices at two time intervals "In order for the line to advance, the price gains for the last day's close must be ‘greater than the gains of 10 days ago" "If prices advance by only the same amount as 10 days ago, the momentum line will be fat If the last price gain is less than that of 10 days ago, the momen- tum line begins to decline even though prices are sill rising" "This i how the momentum line measures the acceleration or deceler- ation in the current advance or decline in the price tend ‘The Momentum Line Leads the Price Action Because of the way it is constructed, the momentum line is always 4 step ahead of the price movement" "It leads the advance or three day patterns that work excep- tonally well The scenario for under- standing the change in trader psychology for the Evening Star will be thoroughly discussed here since the opposite can be said for the Morning Star (See Figures 12 8 and 12 9 ) fl) il ‘ Figure 128 Evening star Figure 12 "9 Moming star + 304 chapter 12 ‘The Evening Star is a bearish reversal candle patter, as its ‘name suggests" The fist day of this pattern is a long white candle- stick which fully enforces the current uptrend "On the open of the second day, prices gap up above the body of the first day" Trading ‘on this second day is somewhat restricted and the close price is near the open price while remaining above the body of the first day The body for the second day is small This type of day following a long day is referred to as a Star pattern A Star is a small body day that ‘gaps away from a long body day The third and last day ofthis pat- tern opens with a gap below the body of the star and closes lower ‘with the close price below the midpoint of the first day ‘The previous explanation was the perfect scenario "Many references will accept as valid, an Evening Star which does not ‘meet each detail exactly" "For instance, the third day might not gap ‘down or the close on the third day might not be quite below the ‘midpoint of the first day’s body" "These details are subjective when viewing a candlestick chart, but not when using a computer pro- {gram to automatically identify the patterns" "That is because com- uter programs require explicit instructions to read the candle chart, and don’t allow for subjective interpretation" "Continuation Patterns Each trading day, a decision needs to be made, whether it is to exit a trade, enter a trade, or remain in a trade" A candle pattern that hhelps identify the fact that the current trend is going to continue is more valuable than may first appear It helps answer the ques- tion as to whether or not you should remain in a trade Japanese literature refers to 16 continuation candle patterns One continu- ation pattern and its related opposite cousin are particularly good at trend continuation identification Rising and Falling Three Methods "The Rising Three Methods con- ‘inuation candle pattern is the bullish counterpart to this duo and ‘will be the subject of this scenario building, A bullish continua tion pattern can only occur in an uptrend and a bearish continu- ation pattem can only occur in a downtrend" This restates the required relationship to the trend that is so necessary in candle pattern analysis (See Figures 12 10 and 12 11 ) Jepanete Condes 305 | Figure 12 10 Rising Three Figure 12 11 Falling Three Methods + "Methods ~ a fll i , ao | The first day of the Rising Three Methods pattern is a long" white day which fully supports the uptrending market "However, over the course of the next three trading periods, small body days ‘occur which, as a group, trend downward" They all remain with- in the range of the first day's long white body and at least two of these three small-bodied days have black bodies "This period of time when the market appears to have gone nowhere is consid ‘ered by the Japanese as a ""period of rest" """ On the fifth day of this ppattemn, another long white day develops which closes at a new high" "Prices have finally broken out of the short trading range and, the uptrend will continue" ‘A five day pattern such as the Rising Three Methods requires a lot of detail in its definition The above scenario is the perfect example of the Rising Three Methods pattern Flexibility an be applied with some success and this only comes with experience "For example, the three small reaction days could remain within the first day’s high-low range instead of the body's range" The small reaction days do not always have to be predominantly black "And finally, the concept of the “period of rest” could be expanded to include more than three reaction ‘days" "Don’t ignore the Rising and Falling Three Methods pat- tern; it can give you a feeling of comfort when worrying about protecting profits in a trade, 306 Chapter 12 Using Computers for Candle Pattern Identification |A personal computer with software designed to recognize candle [patterns is a great way to remove emotion, especially during a trade" "However, there are a couple of things to keep in mind when viewing candlesticks on a computer screen" A computer screen is made up of small light elements called pixels "There are only so many pixels on your computer screen, with the amount based upon the resolution of your video card/monitor combina- ton" "If you are viewing price data that has a large range of prices in a short period of time, you may think that you are seeing ‘many Doji days (open and close price are equal) when in fact, you are not, With a large range of prices on the screen, each pixel element will have a price range of its own" A computer software program that identifies patterns based on a mathemat- ical relationship will overcome this visual anomaly "Hopefully, the above explanation will keep you from thinking that your software isn’t working, FILTERED CANDLE PATTERNS: A revolutionary concept developed by Greg Mortis in 1991, called ‘candle pattern filtering, provides a simple method to improve the ‘overall reliability of candle patterns" "While the short term trend ‘of the market must be identified before a candle pattern can exist, determination of overbought and oversold markets using tradi- tonal technical analysis will enhance a candle pattern's predictive ability" "Concurrently, this technique helps eliminate bad or pre- ‘mature candle patterns" ‘One must first grasp how a traditional technical indicator responds to price data "In this example, Stochastics %D will be used" "The stochastic indicator oscillates between 0 and 100, with 20 being oversold and 80 being overbought" "The primary inter- pretation for this indicator is when %D rises above 80 and then falls below 80, a sell signal has been generated" "Similarly, when it drops below 20 and then rises above 20, a buy signal is given" (See Chapter 10 for more on Stochastics ") Ieponese Condesticks 307 Here is what we know about stochastics %D: When it enters the area above 80 or below 20, it will eventually generate a signal" "In other words, itis just a matter of time until a signal fs given" The area above 80 and below 20 is called the presignal area and represents the area that 96D must get to before it can give a trading signal of its own (See Figure 12 12 ) Figure 12 12 ‘The filtered candle pattern concept uses this presignal area Candle patterns are considered only when 96D is in its presignal area "Ifa candle pattern occurs when stochastics 96D is at, say 65, the pattern is ignored" "Also, only reversal candle patterns are con: sidered using this concept" Candle patter filtering is not limited to using stochastics 96D Any technical oscillator that you might normally use for analysis can be used to filter candle patterns "Wilder's RSI, Lambert's CCI, and Williams’ 96R are a few that will work equally 4s well" (These oscillators are explained in Chapter 10 ) 308 Chapter 12 CONCLUSION Japanese candlestick charting and candle pattern analysis are essential tools for making market timing decisions "One should ‘use Japanese candle patterns in the same manner as any other technical tool or technique; that is, to study the psychology of ‘market participants" "Once you become used to seeing your price charts using candlesticks, you may not want to use bar charts again" "Japanese candle patterns, used in conjunction with other ‘technical indicators in the filtering concept, will almost always offer a trading signal prior to using other price-based indicators" CANDLE PATTERNS “The candle pattems listed below comprise the Hocary thats used to dently candlestick signals The number in parentheses atthe end of ‘each name represents the number of candles that are used to define ‘that particular patter "The bullsh and bearsh patterns are divided into two groups signifying ether reversal or continuation patterns Bulish Reversals Bearish Reversals ang wivte ody (1) {Lang Black Body (1) ammer (1) Hanging Man (1 Inverted Hammer (1) Shooung Star (1) bait Hold (1) Bel nol (1 Exgutng Pater (2) Enguting Pater (2) farm’ @) Harem (@) Haram Cros (2) Maram Cross 2) Percing Une Dark clous Cove (2) Dol star (2) Daj star(2) ‘Meeting Lines (2) ‘Meeting Lins (2) Three White Soles (3) Three Black Crow (3) Morning Star @) vering Sta 3) Morning Do Star (3) [Evening Doj Star (3) Abandoned Baby (3) ‘Aoandorea Baby 3) Tester) Taste 3) Breakaway (5) Brestaway (5) Tivee Inside Up (3) Three inside Down (3) ‘Three Outside Up (3) “Tver Outside Down (3) ‘oaing @) Kicking 2) Unique Tree Rivers Botom (3) Latter Top (5) ‘oe Stas in the South (3) Matching High (2) Conceaing Swallow (4) Upsie Gap Two Crows (3) ‘tek Sana (3) ‘ental The Crows (3) Homing Pigeon (2) Deliberation 3) Leder Bator (3) ‘Advance Bock (3) Matching Low (2) “wo Cows G3) Balsh Continuation ‘Bearish Continuation Separating ins (2) Separating Lines 2) Aaing Teee ethos (5) Faling Three Methods (8) Upside Task Cap (3) Downside Task Cap (3), ‘Sle by Sde White Lines (2) Side by Se White Lines (3) “Tvee Line Strike (4) “vee Line tke) \pside Gap Tee Methods (3) Dowie Cap Thee Methods (3) (On Neck Line 2) ‘On Neck Line (2) in Mech tine 2) neck Une @) Inverted Hammer + Enguling + Enguting — Haram + Harami Cross ~ Morning Star + Breakaway + Stick Sandwich + denical Three Matching Low + Rising Three “Three Line Strike ~ HISTORICAL BACKGROUND In 1938, a monograph entitled The Wave Principle was the first published reference to what has come to be known as the Elliott Wave Principle" "The monograph was published by Charles J Collins and was based on the original work presented to him by the founder of the Wave Principle, Ralph Nelson (R" "N,) Elliott" "Elliott was very much influenced by the Dow Theory, which has much in common with the Wave Principle" "In a 1934 letter to Collins, Elliott mentioned that he had been a subscri to Robert Rhea's stock market service and was familiar with Rhea's book on Dow Theory" Elliott goes on to say that the Wave Principle was “a much needed complement to the Dow Theory "” In 1946, just two years before his death, Elliott wrote his definitive work on the Wave Principle, Nature's Law—The Secret of ‘the Universe" Elliott's Ideas might have faded from memory if A "Hamilton Bolton hadn't decided in 1953 to publish the Elliott Wave Supplement to the Bank Credit Analyst, which he did annual- 319 320 Choper 13 ly for 14 years, until his death in 1967" AJ Frost took over the Elliott Supplements and collaborated with Robert Prechter in 1978 on the Elliott Wave Principle Most of the diagrams in this chapter are taken from Frost and Prechter’s book Prechter went a step further and in 1980 published The Major Works of R N "Elliott, ‘making available the original Elliott writings that had long been out of print BASIC TENETS OF THE ELLIOTT WAVE PRINCIPLE ‘There are three important aspects of wave theory—pattern, ratio, and time—in that order of importance" Pattem refers to the wave patterns or formations that comprise the most important element Of the theory "Ratio analysis is useful in determining retracement points and price objectives by measuring the relationships between the different waves, Finally, time relationships also exist and can be ‘used to confirm the wave pattems and ratios, but are considered by some Elliotticians to be less reliable in market for 3" "Elliott Wave Theory was originally applied to the major stock market averages, particularly the Dow Jones Industrial Average" "In its most basic form, the theory says that the stock market follows 2 repetitive rhythm of a five wave advance fol- lowed by a three wave decline" Figure 13 1 shows one complete cycle "If you count the waves, you will find that one complete ‘eycle has eight waves—five up and three down" In the advancing "portion of the cycle, notice that each of the five waves are num: bered" "Waves 1, 3, and S—called impulse waves—are rising waves, while waves 2 and 4 move against the uptrend, Waves 2 and 4 are called corrective waves because they correct waves 1 and 3" "After the five wave numbered advance has been completed, a three wave correction begins" "The three corrective waves are identified by the letters a, b,c" "Along with the constant form of the various waves, there 4s the important consideration of degree" There are many differ- ent degrees of trend "Elliot, in fact, categorized nine different degrees of trend (or magnitude) ranging from a Grand Supercycle ‘ott Wave Theay 321 Figure 13" 1 The Basic Pattem (AJ "Frost and Robert Prechter, Eliott ‘Wave Principle (Gainesville, GA: New Classics Libary, 1978] p" 20 "Copyright © 1978 by Fost and Prchter) spanning two hundred years to a subminuette degree covering only a few hours, The point to remember is that the basic eight wave cycle remains constant no matter what degree of trend being studied" "Each wave subdivides into waves of one lesser degree that, in tum, can also be subdivided into waves of even lesser degree" It also follows then that each wave is itself part of the wave of the next higher degree Figure 13 2 demonstrates these relationships "‘The largest two waves—1 and 2—can be subdivided into eight lesser waves that, in tum, can be subdivided into 34 even lesser ‘waves" The two largest waves—1 and 2—are only the first two waves in an even larger five wave advance Wave 3 of that next higher degree is about to begin The 34 waves in Figure 13 2 are subdivided further to the next smaller degree in Figure 13 "3, resulting in 144 waves" Veaesemew 3 wor Figure 13 "2 (Prost and Prchter, p" 21 "Copyright © 1978 by Frost and Prechter) ‘The numbers shown so far 1,2,3,5,8,13,21,34,55,89,144— are not just random numbers" "They are part of the Fibonacci num- ber sequence, which forms the mathematical basis for the Elliott Wave Theory" We'll come back to them a little later "For now, look at Figures 13" "1-13,3 and notice a very significant characteristic of the waves" Whether a given wave divides into five waves or three ‘waves is determined by the direction of the next larger wave "For example, in Figure 13" "2, waves (1), (3), and (S) subdivide into five ‘waves because the next larger wave of which they are part—wave 1—is an advancing wave" "Because waves (2) and (4) are moving against the trend, they subdivide into only three waves" "Look ‘more closely at corrective waves (a), (b), and (c), which comprise the larger corrective wave 2" "Notice ‘that the two declining waves—(a) and (c)—each break down into five waves, This is ttt Wave Theory 323 seu" Co Pa TORRE Ran CTE Figure 13 "3 (Frost and Freche, p" 22 "Copyright © 1978 by Frost and Prechter) because they are moving in the same direction as the next larger wave 2, Wave (b) by contrast only has three waves, because it is ‘moving against the next larger wave 2" ‘Being able to determine between threes and fives is obvious- ly of tremendous importance in the application of this That information tells the analyst what to expect next "A completed five wave move, for example, usually means that only part of a larg er wave has been completed and that there's more to come (unless ita fifth ofa fifth)" One ofthe most important rules to remember is that 4 comection can never take place in five waves "In a bull market, for ‘example, fa five wave decline is seen, this means that itis probably only the first wave of a three wave (a-b-) decline and that there's more to come on the downside, In a bear market, a three wave ‘advance should be followed by resumption of the downtrend" "A five ‘wave rally would warn of a more substantial move to the upside and ight possibly even be the fist wave of a new bull trend, 324 Chapter 13, CONNECTION BETWEEN ELLIOTT ‘WAVE AND DOW THEORY Let’ take a moment here to point out the obvious connection between Eliot's idea of five advancing waves and Dow's three advancing phases of a bull market" "It seems clear that Eliot's idea ff three up waves, with two intervening corrections, fits nicely with the Dow Theory" "While Elliott was no doubt infiuenced by Dow's analysis, it also seems clear that Elliot believed he had {gone well beyond Dow's theory and had in fact improved on it" Its also interesting to note the influence of the sea on both men in the formulation of their theories "Dow compared the major, intermediate, and minor trends in the market with the tides, waves, and ripples on the ocean, Elliott referred to “ebbs and flows"" in his waiting and named his theory the “wave” prinaiple CORRECTIVE WAVES So far, we've talked mainly about the impulse waves in the direc- tion of the major trend" Let’ turn our attention now to the cotrec- tive waves "In general, corrective waves are less clearly defined and, aa result, tend to be more difficult to identify and predict" "One point that is clearly defined, however, Is that corrective waves can never take place in five waves" "Corrective waves are threes, never fives (with the exception of triangles)" "We're going to look at three classifications of corrective waves—zig-zags, flats, and triangles ‘Zig-Zags ‘A zig-zag is a three wave corrective pattern, against the major ‘trend, which breaks down into a 5-3-5 sequence" Figures 13 "4 and, 13" "5 show a bull market zig-zag correction, while a bear market rally is shown in Figures 13" 6 and 13 7 Notice that the middle ‘wave B falls short of the beginning of wave A and that wave C ‘moves well beyond the end of wave A A less common variation of the zig-zag is the double zig- ‘zag shown in Figure 13 "8, This variation sometimes occurs In larg er corrective patterns" Its in effect two different 5-3-5 zig-zag pat- terns connected by an intervening a-b-c pattern : © Figure 13 4 ll Market Zig Zag Figure 13 8 Bull Market Zig-Zag (5:35) "(Fost and Prechter,p" "$6, (5-35)" "(Frst and Prechter," 36 Copyright ©1978 by Frst and Copyright © 1978 by Frost and Prechter) Precher) Figure 13 6 Bear Market Zig-Zag Figure 13 7 Bear Market Zig- (5:35) "(Fost and Prechter, p" 36 Zag (5-35) "(Frost and Prechte, p Copyright © 1978 by Frost and [36 Copyright © 1978 by Frost and Prechte,) Prechter) 326 Copter 13 Figure 13" 8 Double Zig-Zag "(Frost and Precter,p" 37 Copyright © 1978 by Frost and Prechter) Flats ‘What distinguishes the flat correction from the zig-zag correction 1s that the flat follows a 3-3-5 pattern Notice in Figures 13 10 and 13 12 that the A wave Is a 3 Instead of a 5 "In general, the flat is ‘more of a consolidation than a correction and is considered a sign, of strength in a bull market" Figures 13 9-13 12 show examples of ‘normal flats "In a bull market, for example, wave B rallies all the way to the top of wave A, showing greater market strength" "The final wave C terminates at or just below the bottom of wave A in contrast to a zigzag, which moves well under that point" There are two “irregular” variations of the normal flat cor- rection Figures 13 13-13 16 show the first type of variation Notice in the bull market example (Figures 13 13 and 13 14) that the top of wave B exceeds the top of A and that wave C violates the bottom of A "‘Another variation occurs when wave B reaches the top of A, bbut wave C fails to reach the bottom of A" "Naturally, this last pat tem denotes greater market strength in a bull market" This varia tion is shown in Figures 13 17-13 "20 for bull and bear markets, ‘ott Wave Theory 327 n ni a g a € Figure 13" 9 Bull Market at 3 Figure 13 "10 Bull Market Flat 3- ‘45), Normal Corection" "Frst and 3-5), Normal Corton" "(Fost and ‘Prec," "38, Copyright © 1978 by Prchtr, p" 38 Copyright © 1978 by ‘Frost and Pechte) Frost and Prechter) igure 13 "11 Bear Markt Plat (535), Namal Corecion" "Frost ‘and Pech, p" 38 Copyright © 1978 by Frost and Prechter) Figure 13 12 Bear Market Fat 3- 3 "8), Normal Conection" "(Frost and Precher,p" 38 "Copyright © 1978 by Frost and Pechtr) 328 Chaper 13, t igure 13" 13 "Bull Market Flat 3 {38}, lneular Comecton" Fret and Prechterp 39 Copyright ©1978 by Frostand Prechter) Figure 13 14 Bull Market Flat @- 3 "3), regular Corection" "(Fast ant Dreher, p" 39 Copyright © 1918 by Frost and Prechte) Figure 13 "15 Bear Market Fat (3), Imegular Coretion" "Past and Precher,p" 38 Copyright © 1978 by Frost and Precher) Figure 13 "16 Bear Market Fat (3- 39), egular Comection" (Frost and Prechter p 39 Copyright © 1978 by Frost and Prete) tt Weve Theory 329 Figure 13 17 ull Market Flat @- Figure 18 "18 Bull Market Plat 138), Inverted Imegular Correction" (3-3-5) ImertedImegular Corection (rast and Prechtr p 40 "Copyright (Bost and Prechtr,p" "40, Copyright (© 1978 by Frost and Prechter) {© 1978 by Frost and Prechter) Figure 13" 19 Bear Market Fat Figure 13 "20 Bear Market Flat (35), Inverted Imegular Comection" "(3-38), Inverted inegular Corection" (Frost and Prechter p 40 "Copyright (Fost and Prechtr,p" 40 "Copyright (© 1978 by Frost and Prechter) (© 1978 by Frost and Prechter) Triangles ‘Triangles usually occur in the fourth wave and precede the final ‘move in the direction of the major trend, (They can also appear in the b wave of an a-b-c correction" ") In an uptrend, therefore, it can be said that triangles are both bullish and bearish" They're bullish in the sense that they indicate resumption of the uptrend "‘They're bearish because they also indicate that after one more ‘wave up, prices will probably peak" (See Figure 13 21 ) 330 chpter 13 BULL MARKET BEAR MARKET ‘ASCENDING (Top flat bottom rising) Figure 13 21 Corrective Wave (Horizontal) Triangles "Frost and Prechter, p" 43 "Copyright © 1978 by Frost and Prechter) ott Wave Theory 331 Elliott's interpretation of the triangle parallels the classical use of the patter, but with his usual added precision" "Remember from Chapter 6 that the triangle is usually a continuation pattern, which is exactly what Eliott said" "Eliott’s triangle is a sideways consolidation pattern that breaks down into five waves, each ‘wave in turn having three waves of its own" "Eliott also classifies four different kinds of triangles—ascending, descending, symmetri- cal, and expanding—all of which were seen in Chapter 6" Figure 13 21 shows the four varieties in both uptrends and downtrends "Because chart patterns in commodity futures contracts sometimes don't form as fully as they do in the stock market, it is not unusual for triangles in the futures markets to have only three waves instead of five" "(Remember, however, that the minimum, requirement for a triangle is still four points—two upper and two Jower—to allow the drawing of two converging trendlines" ") Elliott Wave Theory also holds that the fifth and last wave within the tri- angle sometimes breaks its trendline, giving a false signal, before beginning its “thrust” in the original direction" "Elliott's measurement for the fifth and final wave after completion of the triangle is essentially the same as in classical charting—that is, the market is expected to move the distance that matches the widest part of the triangle (ts height)" There Is another point worth noting here concerning the timing of the final top or bottom "According to Prechter, the apex of the trian- gle (the point where the two converging trendlines meet) often ‘marks the timing for the completion of the final fifth wave" "THE RULE OF ALTERNATION In its more general application, this rule or principle holds that the market usually doesn’t act the same way two times in a row" "If a certain type of top or bottom occurred the last time around, it will probably not do so again this time" "The rule of alternation doesn’t tell us exactly what will happen, but tells us what proba- bly won't" "In its more specific application, it is most generally used to tell us what type of corrective pattern to expect" "Corrective patterns tend to alternate, In other words, if corrective 332 Chepter 13 ‘wave 2 was a simple a-b-c pattern, wave 4 will probably be a com- plex pattern, such as a triangle" "Conversely, if wave 2 is complex, Wave 4 will probably be simple" Figure 13 22 gives some examples ba rae Figure 13 22 The Rule of Altemation "(Fast and Prechte,p" 50 "Ciprih 1978 0 Pst end rece) (CHANNELING Another important aspect of wave theory is the use of price chan- res, You'll recall that we covered trend channeling in Chapter 4" Elliott used price channels as a method of arriving at price objec- tives and also to help confirm the completion of wave counts "Once an uptrend has been established, an initial trend channel is ‘constructed by drawing a basic up trendline along the bottoms of waves 1 and 2" A parallel channel line is then drawn over the top of wave 1 as shown in Figure 13 23 "The entire uptrend will often stay within those two boundaries If wave 3 begins to accelerate to the point that it exceeds the upper charinel line, the lines have to be redrawn along the top of wave 1 and the bottom of wave 2 as shown in Figure 13" 23 The final channel is drawn under the two corrective waves—2 and 4—and usually above the top of wave 3 as shown in Figure 13 24 "If wave 3 1s unusually strong, or an extended Bott Wave Theory 333 Figure 13" 23 (Old and New Channels "Prost ‘and Prechter,p" 62 Copyright © 1978 by Frost ‘and Prechter) ge ¥ Figure 13 24 ‘Fal Channel "(rast and Precitr, p" 63 "Copyright © 1978 by é Frost and Prechter) 334 Chapter 13, wave, the upper line may have to be drawn over the top of wave 1" The fifth wave should come close to the upper channel line before terminating "For the drawing of channel lines on long term trends, it’s recommended that semilog charts be employed along with arithmetic charts WAVE 4 AS A SUPPORT AREA" "In concluding our discussion of wave formations and guidelines, ‘one important point remains to be mentioned, and that is the sig nificance of wave 4 as a support area in subsequent bear markets" "Once five up waves have been completed and a bear trend has begun, that bear market will usually not move below the previous fourth wave of one lesser degree; that is, the last fourth wave that was formed during the previous bull advance" "There are excep- tions to that rule, but usually the bottom of the fourth wave con- tains the bear market" This piece of information can prove very useful in arriving at a maximum downside price objective FIBONACCI NUMBERS AS THE BASIS OF THE WAVE PRINCIPLE Elliott stated in Nature's Law that the mathematical basis for his Wave Principle was a number sequence discovered by Leonardo Fibonacci in the thirteenth century That number sequence has become identified with its discoverer and is commonly referred to as the Fibonacci numbers "The number sequence is 1, 1, 2, 3, 5, 8, 13, 21, 34, 5S, 89, 144, and so on to infinity" "The sequence has a number of interesting properties, not the least of which is an almost constant relationship between the numbers" 1 The sum of any two consecutive numbers equals the next higher number "For example, 3 and 5 equals 8, 5 and 8 equals 13, and so on, 2" The ratio of any number to its next higher number approaches "618, after the first four numbers" "For example, tt WoveThexy 335 1/1 is 1" "00, 1/2" "is $0, 2/3 is" "67, 3/5 is" "60, 5/8 is 625, 8/13, 4s" "615, 13/21 1s" "619, and so on" Notice how these early ratio values fluctuate above and below 618 in narrowing amplitude "Also, notice the values of 1" "00," "50," 67 "We'll ‘comment further on these values when we talk more about ratlo analysis and percentage retracements, 3" The ratio of any number to its next lower number is approx- imately 1 "618, or the inverse of" 618 "For example, 13/8 is 1,625, 21/13 1s 1" "615, 34/21 is 1" 619 "The higher the numbers become, the closer they come to the values of 618 and 1" 618 4 The ratios of alternate numbers approach 2 "618 or its inverse," "382, For example, 13/34 is" "382, 34/13 is 2" 615 "FIBONACCI RATIOS AND RETRACEMENTS It was already stated that wave theory is comprised of three aspects—wave form, ratio, and time, We've already discussed ‘wave form, which is the most important of the three" Let’s talk now about the application of the Fibonacci ratios and retracements "‘These relationships can apply to both price and time, although the former is considered to be the more rellable, We'll come back later to the aspect of time" "First of all, a glance back at Figures 13" 1 and 13 3 shows ‘that the basic wave form always breaks down into Fibonacci num- bers "One complete cycle comprises eight waves, five up and three down—all Fibonacci numbers" Two further subdivisions will pro- ‘duce 34 and 144 waves—also Fibonacci numbers "The mathemat- ical basis of the wave theory on the Fibonacci sequence, however, ‘goes beyond just wave counting" There's also the question of pro- portional relationships between the different waves The follow- Ing are among the most commonly used Fibonacci ratios: 1 One of the three impulse waves sometimes extends The ‘other two are equal in time and magnitude "If wave S extends, waves 1 and 3 should be about equal" "If wave 3 extends, waves 1 and 5 tend toward equality 336 chapter 13 2" Aminimum target for the top of wave 3 can be obtained by ‘multiplying the length of wave 1 by 1 618 and adding that total to the bottom of 2 3 The top of wave S can be approximated by multiplying wave I by 3 236 (2x1 618) and adding that value to the top or bottom of wave 1 for maximum and minimum targets "4, Where waves 1 and 3 are about equal, and wave Sis expect- ed to extend, a price objective can be obtained by measur- ing the distance from the bottom of wave 1 to the top of wave 3, multiplying by 1" "618, and adding the result to the bottom of 4 S" "For corrective waves, in a normal 5-3-5 zig-zag correction, wave cs often about equal to the length of wave a" 6 Another way to measure the possible length of wave cis to ‘multiply 618 by the length of wave 2 and subtract that result from the bottom of wave a 7 "In the case of a flat 3-3-5 correction, where the b wave reaches or exceeds the top of wave a, wave will be about 1" 618 the length of a 8 "Ina symmetrical triangle, each successive wave is related to {ts previous wave by about" "618, Fibonacci Percentage Retracements ‘The preceding ratios help to determine price objectives in both impulse and corrective waves" Another way to determine price “objectives is by the use of percentage retracements The most com= monly used numbers in retracement analysis are 61 "8% (usually rounded off to 62%), 38%, and 50%" "Remember from Chapter 4 that markets usually retrace previous moves by certain predictable percentages—the best known ones being 33%, SO%, and 6796" ‘The Fibonacet sequence refines those numbers a bit further "In a strong trend, a minimum retracement is usually around 389%" "In a weaker trend, the maximum percentage retracement is usually (6296" (See Figures 13 25 and 13 26 ) Figure 13 "25 The three horizontal lins show Fibonnaci retacement lev- 1s of 38%, SOP, and 62% measured From Uhe 1981 bottom to the 1993 peak in Treasury Bonds" The 1994 corection in bond prices stopped right at {the 38% retracement Ine Figure 13 26 The dee Fibonacci pacentage lines are measured forthe 1994 bottom in bond prices to the early 1996 top "Bond prices coreced to the 62% line 338 Chapter 13 It was pointed out earlier, that the Fibonacci ratios approach" 618 only after the first four numbers "The first three ratios are 1/1 (100%), 1/2 (50%), and 2/3 (66%)" "Many students of Elliott may be unaware that the famous 50% retracement is actu- ally a Fibonacci ratio, as Is the two-thirds retracement" A complete retracement (100%) of a previous bull or bear market also should ‘mark an important support or resistance area FIBONACCI TIME TARGETS We haven't said too much about the aspect of time in wave analysis Fibonacci time relationships exist I's just that they're harder to predict and are considered by some Elliotticians to be the least important of the three aspects of the theory Fibonacci time targets are found by counting forward from significant tops and bottoms "On a daily chart, the analyst counts forward the ‘number of trading days from an important turning point with the expectation that future tops or bottoms will occur on Fibonacci days—that is, on the 13th, 2ist, 34th, 55th, or 89th trading day in the future" "The same technique can be used on weekly, monthly, or even yearly charts" "On the weekly chart, the analyst picks a significant top or bottom and looks for weekly time targets that fall on Fibonacci numbers" (See Figures 13 27 and 13 28 ") COMBINING ALL THREE ASPECTS OF WAVE THEORY The ideal situation occurs when wave form, ratio analysis, and time targets come together" "Suppose that a study of waves reveals that a fifth wave has been completed, that wave § has gone 1" "618 times the distance from the bottom of wave 1 to the top of wave 3, and that the time from the beginning of the trend has been 13 Weeks from a previous low and 34 weeks from a previous top" Suppose further that the fifth wave has lasted 21 days Odds would be pretty good that an important top was neat Figure 13 27 Fibonacci time targets measured in months ffom the 1981 bottom in Treasury Bonds "It may be coincidence, but the last four Fibonacct time targets (vertical bars) colnclded with important turns in Bond prices" Figure 13 28 Fibonacci time targets in months from the 1982 bottom in the Dow "The last Ue vertical bars coincide with bear market years in stocks 1987, 1990, and 1998, The 1987 peak was 13 years fom the 1982 bottom—a Fibonacel number" 340 Chepter 13 AA study of price charts in both stocks and futures markets reveals a number of Fibonacci time relationships "Part of the prob- Jem, however, is the variety of possible relationships" "Fibonacci time targets can be taken from top to top, top to bottom, bottom to bottom, and bottom to top" These relationships can always be found after the fact "It’s not always clear which of the possible relationships are relevant to the current trend, ELLIOTT WAVE APPLIED TO" STOCKS VERSUS COMMODITIES ‘There are some differences in applying wave theory to stocks and commodities "For example, wave 3 tends to extend in stocks and wave 5 in commodities" The unbreakable rule that wave 4 can never overlap wave 1 in stocks Is not as rigid In commodities (intraday penetrations can occur on futures charts ) Sometimes Charts of the cash market in commodities give a clearer Elliot pat- ‘tem than the futures market The use of continuation charts in commodity futures markets also produces distortions that may affect long term Elliott patterns "Possibly the most significant difference between the two areas is that major bull markets in commodities can be “con- tained,” meaning that bull market highs do not always exceed previous bull market highs" It is possible in commodity markets for a completed five wave bull trend to fall short of a previous bull market high The major tops formed in many commodity markets in the 1980 to 1981 period failed to exceed major tops formed seven and eight years earlier "As a final comparison between the ‘two areas, it appears that the best Elliott patterns in commodity markets arise from breakouts from long term extended bases" Its important to keep in mind that wave theory was origi- nally meant to be applied to the stock market averages It doesn't ‘work as well in individual common stocks It's qulte possible that it doesn’t work that well in some of the more thinly traded futures ‘markets as well because mass psychology is one of the important foundations on which the theory rests "Gold, as an illustration, is an excellent vehicle for wave analysis because of its wide following, tt Weve They 341 SUMMARY AND CONCLUSIONS Let’ briefly summarize the more important elements of wave the- ‘ory and then try to put it into proper perspective" 1 "A complete bull market cycle Is made up of eight waves, five up waves followed by three down waves" 2 Attend divides into five waves in the direction of the next longer trend 3 Corrections always take place in three waves 4 The two types of simple corrections are zig-zags (S-3-5) and flats (3-3-5) 5 "Trlangles are usually fourth waves, and always precede the final wave, Triangles can also be B corrective waves" "6, Waves can be expanded into longer waves and subdivided Into shorter waves" 7 Sometimes one of the impulse waves extends The other two should then be equal in thme and magnitude {8 The Fibonacci sequence Is the mathematical basis of the Elliott Wave Theory 9 The number of waves follows the Fibonace! sequence "10, Fibonacci ratios and retracements are used to determine price objectives" "The most common retracements are 62%, 50%, and 38%, 11" The rule of alternation warns not to expect the same thing twice in succession 12 Bear markets should not fall below the bottom of the pre- vious fourth wave "13, Wave 4 should not overlap wave 1 (not as rigid in futures) 14" "The Elliott Wave Theory is comprised of wave forms, ratios, and time, in that order of importance" 15 "The theory was originally applied to stock market averages, and does not work as well on individual stocks" 16 "The theory works best in those commodity markets with the largest public following, such as gold" 342 Chapter 13 17 The principal difference in commodities is the existence of contained bull markets "The Elliott Wave Principle builds on the more classical approaches, such as Dow Theory and traditional chart patterns" "Most of those price patterns can be explained as part of the Elliott ‘Wave structure, It builds on the concept of “swing objectives” by using Fibonacci ratio projections and percentage retracements, ‘The Elliott Wave Principle takes all of these factors into consider- ation, but goes beyond them by giving them more order and Increased predictability" ‘Wave Theory Should Be Used in Conjunction with Other Technical Tools ‘There are times when Elliott pictures are clear and other times ‘when they are not "Trying to force unclear market action into an Elliot format, and Ignoring other technical tools in the process, is ‘a misuse of the theory" The key is to view Elliott Wave Theory as a partial answer to the puzzle of market forecasting Using it in con- junction with all of the other technical theories in this book will Increase its value and improve your chances for success REFERENCE MATERIAL ‘Two of the best sources of information on Elliott Wave Theory and the Hbonacci numbers are The Major Works of RN "Elliot, (Prechter, J) and the Elliot Wave Principle (Frost and Prechitet)" A of the diagrams used in Figures 13 1-13 24 are from the Elliott Wave Principle and ate reproduced in this chapter through the courtesy of New Classis Library "‘A primer booklet on the Fibonacci numbers, Understanding Fibonacci Numbers by Edward D" "Dobson, is available from Traders Press (P" O "Box 6206, Greenville, S" C "29606 (800-927-8222), INTRODUCTION ‘Our main focus up to this point has been on price movement, and ‘not too much has been said about the importance of time in solv- ing the forecasting puzzle" "The question of time has been present by implication throughout our entire coverage of technical analy- sis, but has generally been relegated to secondary consideration" "In this chapter, we're going to view the problem of forecasting through the eyes of cyclic analysts who believe that time cycles hold the ultimate Key to understanding why markets move up or down" "In the process, we're going to add the important dimen- sion of time to our growing list of analytical tools" "Instead of just asking ourselves which way and how far a market will go, we'll start asking when it will arrive there or even when the move will begin" Consider the standard daily bar chart "The vertical axis, ‘gives the price scale, But that's only half of the relevant data" The horizontal scale gives the time horizon "Therefore, the bar chart is really atime and price chart" "Yet, many traders concentrate solely ‘on price data to the exclusion of time considerations" "When we 343 344 Copter 14 study chart patterns, we're aware that there Is a relationship between the amount of time it takes for those patterns to form land the potential for subsequent market moves" "The longer a trendline or a support or resistance level remains in effect, the ‘more valid it becomes" Moving averages require input as to the proper time period to use Even oscillators require some decison 4s to how many days to measure "In the previous chapter, we con- Sidered the usefulness of Fibonacci time targets" 1 seems clear then that all phases’ of technical analysis