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iathh hyI eenate
 
 
Figure 3.10 A monthly bar chart of the U.S. Dollar Index. Each bar rep-resents one month’s price data. By compressing the data even further, themonthly chart allows chart analysis for periods as long as twenty years.
entire month’s price action. Obviously, weekly and monthly chartscompress the price action to allow for much longer range trendanalysis. A weekly chart can go back as much as five years and amonthly chart up to 20 years. It’s a simple technique that helps thechartist 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, andopen interest—we’re ready to look at how that data is interpreted.Remember that the chart only records the data. In itself, it has lit-Chart Construction 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 bettercomparison is a scalpel. In the hands of a gifted surgeon, it canhelp save lives. In the hands of most of us, however, a scalpel isnot only useless, but might even be dangerous. A chart canbecome an extremely useful tool in the art or skill of market fore-casting once the rules are understood. Let’s begin the process. Inthe next chapter, we’ll look at some of the basic concepts of trendand 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 technicalapproach to market analysis. All of the tools used by the chartist-—support and resistance levels, price patterns, moving averages,trendlines, etc.—have the sole purpose of helping to measure thetrend of the market for the purpose of participating in that trend.We often hear such familiar expressions as “always trade in thedirection of the trend,” “never buck the trend,” or “the trend isyour friend.” So let’s spend a little time to define what a trend isand classify it into a few categories.
In a general sense, the trend is simply the direction of themarket, which way it’s moving. But we need a more precise defi-nition with which to work. First of all, markets don’t generallymove in a straight line in any direction. Market moves are char-acterized by a series of zigzags. These zigzags resemble a series ofsuccessive waves with fairly obvious peaks and troughs. It is thedirection of those peaks and troughs that constitutes market trend.Whether those peaks and troughs are moving up, down, or side-
4950 Chapter 4
 
ways tells us the trend of the market. An uptrend would be definedas a series of successively higher peaks and troughs; a downtrend isjust the opposite, a series of declining peaks and troughs; hori-zontal peaks and troughs would identify a sideways price trend.(See Figures 4.1a-d.)
Figure 4.laExample of anuptrend withascending peaksand troughs.
Figure 4.1bExample of adowntrend withdescending peaksand troughs.
 
Figure 4.1cExample of asideways trendwith horizontalpeaks andtroughs. Thistype of market isoften referred toas “trendless.”Basic Concepts of Trend 51
 
(BTW) Dow 20 Bonds
 
Daily Line Chart
Sideways Trend
 
 
 
 
 
 
Figure 4.1d Example of a downtrend turning into an uptrend. The firstportion to the left shows a downtrend. From April 1996 to April 1997, themarket traded sideways. During the summer 1997, the trend turned up.
TREND HAS THREE DIRECTIONS
We've mentioned an uptrend, downtrend, and sideways trend fora very good reason. Most people tend to think of markets as beingalways in either an uptrend or a downtrend. The fact of the mat-ter is that markets actually move in three directions—up, down,and sideways. It is important to be aware of this distinctionbecause for at least a third of the time, by a conservative estimate,ptices move in a flat, horizontal pattern that is referred to as atrading range. This type of sideways action reflects a period of equi-librium in the price level where the forces of supply and demandare in a state of relative balance. (If you'll recall, Dow Theoryrefers to this type of pattern as a line.) Although we've defined aflat market as having a sideways trend, it is more commonlyreferred to as being trendless.52 Chapter 4
 
Most technical tools and systems are trend-following innature, which means that they are primarily designed for marketsthat are moving up or down. They usually work very poorly, ornot at all, when markets enter these lateral or “trendless” phases.It is during these periods of sideways market movement that tech-nical traders experience their greatest frustration, and systemstraders their greatest equity losses. A trend-following system, byits very definition, needs a trend in order to do its stuff. The fail-ure here lies not with the system. Rather, the failure lies with thetrader who is attempting to apply a system designed for trendingmarkets into a nontrending market environment.
There are three decisions confronting the trader—whetherto buy a market (go long), sell a market (go short), or do nothing(stand aside). When a market is rising, the buying strategy ispreferable. 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 THREECLASSIFICATIONS
In addition to having three directions, trend is usually brokendown into the three categories mentioned in the previous chap-ter. Those three categories are the major, intermediate, and nearterm trends. In reality, there are almost an infinite number oftrends interacting with one another, from the very short termtrends covering minutes and hours to superlong trends lasting 50or 100 years. Most technicians, however, limit trend classifica-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 beingin effect for longer than a year. Because futures traders operate ina shorter time dimension than do stock investors, I would beinclined to shorten the major trend to anything over six monthsin the commodity markets. Dow defined the intermediate, or sec-ondary, trend as three weeks to as many months, which alsoappears about right for the futures markets. The near term trendis usually defined as anything less than two or three weeks.Basic Concepts of Trend 53
 
Each trend becomes a portion of its next larger trend. Forexample, the intermediate trend would be a correction in the majortrend. In a long term uptrend, the market pauses to correct itselffor a couple of months before resuming its upward path. That sec-ondary correction would itself consist of shorter waves that wouldbe identified as near term dips and rallies. This theme recurs manytimes—that each trend is part of the next larger trend and is itselfcomprised 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 majoruptrend. But notice that the wave 2-3 also breaks down into threesmaller waves (A, B, C). At point C, the analyst would say that themajor trend was still up, but the intermediate and near termtrends were down. At point 4, all three trends would be up. It isimportant to understand the distinction between the variousdegrees of trend. When someone asks what the trend is in a givenmarket, it is difficult, if not impossible, to respond until you know
 
Figure 4.2a Example of the three degrees of trend: major, secondary, andnear term. Points 1, 2, 3, and 4 show the major uptrend. Wave 2-3 represents@ secondary correction within the major uptrend. Each secondary wave in turndivides into near term trends. For example, secondary wave 2-3 divides intominor waves A-B-C.54 Chapter 4
 
(*DWI X) Dow Industrials
 
Three Degrees of Trend
‘Major Trend Is Up
 
 
 
 
 
 
Figure 4.2b = The major trend (over a year) is up during 1997. A shortterm correction occurred during March. An intermediate correction lastedfrom August to November (three months). The intermediate correction brokedown into three short term trends.
which trend the person is inquiring about. You may have torespond in the manner previously discussed by defining the threedifferent trend classifications.
Quite a bit of misunderstanding arises because of differenttraders’ perceptions as to what is meant by a trend. To long termposition traders, a few days’ to a few weeks’ price action might beinsignificant. To a day trader, a two or three day advance mightconstitute a major uptrend. It’s especially important, then, tounderstand the different degrees of trend and to make sure thatall involved in a transaction are talking about the same ones.
As a general statement, most trend-following approachesfocus on the intermediate trend, which may last for severalmonths. The near term trend is used primarily for timing purpos-es. In an intermediate uptrend, short term setbacks would be usedto initiate long positions.Basic Concepts of Trend 55
 
SUPPORT AND RESISTANCE
In the previous discussion of trend, it was stated that prices movein a series of peaks and troughs, and that the direction of thosepeaks and troughs determined the trend of the market. Let’s nowgive those peaks and troughs their appropriate names and, at thesame time, introduce the concepts of support and resistance.
The troughs, or reaction lows, are called support. The termis self-explanatory and indicates that support is a level or area onthe chart under the market where buying interest is sufficientlystrong 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 Figures4.3a and b.)
Resistance is the opposite of support and represents a pricelevel or area over the market where selling pressure overcomes buy-ing pressure and a price advance is turned back. Usually a resis-
Resistance
Resistance 1
 
Figure 4.3a Shows rising support and resistance levels in uptrend. Points2 and 4 are support levels which are usually previous reaction lows. Points 1and 3 are resistance levels, usually marked by previous peaks.56 Chapter 4
Resistance
Support
 
Figure 4.3b Shows support and resistance in a downtrend.
tance level is identified by a previous peak. In Figure 4.3a, points1 and 3 are resistance levels. Figure 4.3a shows an uptrend. In anuptrend, the support and resistance levels show an ascending pat-tern. Figure 4.3b shows a downtrend with descending peaks andtroughs. In the downtrend, points 1 and 3 are support levelsunder the market and points 2 and 4 are resistance levels over themarket.
In an uptrend, the resistance levels represent pauses in thatuptrend and are usually exceeded at some point. In a downtrend,support levels are not sufficient to stop the decline permanently,but are able to check it at least temporarily.
A solid grasp of the concepts of support and resistance isnecessary for a full understanding of the concept of trend. For anuptrend to continue, each successive low (support level) must behigher than the one preceding it. Each rally high (resistance level)must be higher than the one before it. If the corrective dip in anuptrend comes all the way down to the previous low, it may be anearly warning that the uptrend is ending or at least moving froman uptrend to a sideways trend. If the support level is violated,then a trend reversal from up to down is likely.Basic Concepts of Trend 57
Each time a previous resistance peak is being tested, theuptrend is in an especially critical phase. Failure to exceed a pre-vious peak in an uptrend, or the ability of prices to bounce off theprevious support low in a downtrend, is usually the first warningthat the existing trend is changing. Chapters S and 6 on price pat-terns show how the testing of these support and resistance levelsform pictures on the charts that suggest either a trend reversal inprogress or merely a pause in the existing trend. But the basicbuilding 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 4.4a, that at point 5 prices failed to exceed theprevious peak (point 3) before turning down to violate the previ-ous low at point 4. This trend reversal could have been identifiedsimply by watching the support and resistance levels. In our cov-erage of price patterns, this type of reversal pattern will be identi-fied as a double top.
How Support and Resistance Levels ReverseTheir 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 leadsus to one of the more interesting and lesser known aspects of sup-port and resistance—their reversal of roles. Whenever a support or
Figure 4.4a Exampleof a trend reversal. Thefailure of prices at point5 to exceed the previouspeak at point 3 followedby a downside violationof the previous low atpoint 4 constitutes adownside trend reversal.This type of pattern iscalled a double top.
Resistance
 Resistance
 
Figure 4.4b Example of a bottom reversal pattern. Usually the first signof a bottom is the ability of prices at point 5 to hold above the previous lowat point 3. The bottom is confirmed when the peak at 4 is overcome.
 
(°PSE) Pacific High Tech IndexDaily Bar Chart
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Figure 4.4c Example of a bottom reversal. During January 1998 pricesretested the December support low and bounced off it, forming a second sup-port level. The upside penetration of the middle resistance peak signaled anew uptrend.Basic Concepts of Trend 59
resistance level is penetrated by a significant amount, they reverse theirroles and become the opposite. In other words, a resistance levelbecomes a support level and support becomes resistance. Tounderstand why this occurs, perhaps it would be helpful to dis-cuss some of the psychology behind the creation of support andresistance levels.
The Psychology of Support and Resistance
To illustrate, let’s divide the market participants into three cate-gories—the longs, the shorts, and the uncommitted. The longsare those traders who have already purchased contracts; theshorts are those who have already committed themselves to thesell side; the uncommitted are those who have either gotten outof the market or remain undecided as to which side to enter.
Let’s assume that a market starts to move higher from asupport 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 dipback near that support area again, they could add to their longpositions. The shorts now realize (or strongly suspect) that theyare on the wrong side of the market. (How far the market hasmoved away from that support area will greatly influence thesedecisions, but we'll come back to that point a bit later. ) The shortsare hoping (and praying) for a dip back to that area where theywent 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 twogroups—those who never had a position and those who, forone reason or another, liquidated previously held long posi-tions in the support area. The latter group are, of course, madat themselves for liquidating their longs prematurely and arehoping for another chance to reinstate those longs near wherethey sold them.
The final group, the undecided, now realize that prices aregoing higher and resolve to enter the market on the long side onthe next good buying opportunity. All four groups are resolved to“puy the next dip.” They all have a “vested interest” in that sup-60 Chapter 4
 
port area under the market. Naturally, if prices do decline nearthat support, renewed buying by all four groups will materializeto push prices up.
The more trading that takes place in that support area, themote significant it becomes because more participants have avested interest in that area. The amount of trading in a given sup-port or resistance area can be determined in three ways: theamount 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 orresistance area, the more significant that area becomes. For example,if prices trade sideways for three weeks in a congestion area beforemoving higher, that support area would be more important thanif only three days of trading had occurred.
Volume is another way to measure the significance of supportand resistance. If a support level is formed on heavy volume, thiswould indicate that a large number of units changed hands, andwould mark that support level as more important than if very lit-tle trading had taken place. Point and figure charts that measurethe intraday trading activity are especially useful in identifyingthese price levels where most of the trading took place and, con-sequently, where support and resistance will be most likely tofunction.
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 failed to take, it stands toreason that the more recent the activity, the more potent itbecomes.
Now let’s turn the tables and imagine that, instead of mov-ing higher, prices move lower. In the previous example, becauseprices advanced, the combined reaction of the market partici-pants caused each downside reaction to be met with additionalbuying (thereby creating new support). However, if prices start todrop and move below the previous support area, the reactionbecomes just the opposite. All those who bought in the supportarea now realize that they made a mistake. For futures traders,their brokers are now calling frantically for more margin money.Basic Concepts of Trend 61
Because of the highly leveraged nature of futures trading, traderscannot sit with losses very long. They must put up additionalmargin money or liquidate their losing positions.
What created the previous support in the first place wasthe predominance of buy orders under the market. Now, howev-er, all of the previous buy orders under the market have becomesell orders over the market. Support has become resistance. And themore significant that previous support area was—that is, the morerecent and the more trading that took place there—the morepotent it now becomes as a resistance area. All of the factors thatcreated support by the three categories of participants—the longs,the shorts, and the uncommitted—will now function to put a ceil-ing over prices on subsequent rallies or bounces.
It is useful once in a while to pause and reflect on why theprice patterns used by chartists, and concepts like support andresistance, actually do work. It’s not because of some magic pro-duced by the charts or some lines drawn on those charts. Thesepatterns work because they provide pictures of what the marketparticipants are actually doing and enable us to determine theirreactions to market events. Chart analysis is actually a study ofhuman psychology and the reactions of traders to changing mar-ket conditions. Unfortunately, because we live in the fast-pacedworld of financial markets, we tend to rely heavily on chart ter-minology and shortcut expressions that overlook the underlyingforces that created the pictures on the charts in the first place.There are sound psychological reasons why support and resistancelevels can be identified on price charts and why they can be usedto help predict market movements.
Support Becoming Resistance and ViceVersa: Degree of Penetration
A support level, penetrated by a significant margin, becomes aresistance level and vice versa. Figures 4.5a-c are similar to Figures4.3a and b but with one added refinement. Notice that as pricesare rising in Figure 4.5a the reaction at point 4 stops at or abovethe top of the peak at point 1. That previous peak at point 1 hadbeen a resistance level. But once it was decisively penetrated by62 Chapter 4
 
1 Resistance
 
Figure 4.5a In an uptrend, resistance levels that have been broken by asignificant margin become support levels. Notice that once resistance at point1 is exceeded, it provides support at point 4. Previous peaks function as sup-port on subsequent corrections.
Resistance
 
Figure 4.5b In a downtrend, violated support levels become resistance lev-els on subsequent bounces. Notice how previous support at point 1 becameresistance at point 4.Basic Concepts of Trend 63
 
 
12/19/96 ("NDX) Nasdaq 100 Index
Daily Bar Chart
Becomes
New Supp:
 
 
 
 
 
 
Figure 4.5c Role reversal at play. Once the early 1997 resistance peakwas broken, it reversed roles to become a support level. A year later, the inter-mediate price decline found support right at that prior resistance peak whichhad become new support.
wave 3, that previous resistance peak became a support level. Allof the previous selling near the top of wave 1 (creating the resis-tance level) has now become buying under the market. In Figure4.5b, showing declining prices, point 1 (which had been a previ-ous support level under the market) has now become a resistancelevel over the market acting as a ceiling at point 4.
It was mentioned earlier that the distance prices traveledaway from support or resistance increased the significance of thatsupport or resistance. This is particularly true when support andresistance levels are penetrated and reverse roles. For example, itwas stated that support and resistance levels reverse roles onlyafter a significant penetration. But what constitutes significant?There is quite a bit of subjectivity involved here in determiningwhether a penetration is significant or not. As a benchmark, some64 Chapter 4
 
chartists use a 3% penetration as a criteria, particularly for majorsupport and resistance levels. Shorter term support and resistanceareas would probably require a much smaller number, like 1%. Inreality, 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 roleswhen the market moves far enough away to convince the marketparticipants that they have made a mistake. The farther away themarket moves, the more convinced they become.
The Importance of Round Numbers asSupport and Resistance
There is a tendency for round numbers to stop advances ordeclines. Traders tend to think in terms of important round num-bers, such as 10, 20, 25, 50, 75, 100 (and multiples of 1000), asprice 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 animportant 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 marketthen rallied to just above $500 in the first quarter of 1983 beforefalling to $400. A gold rally in 1987 stopped at $500 again. From1990 to 1997, gold failed each attempt to break through $400.The Dow Jones Industrial Average has shown a tendency to stallat multiples of 1000.
One trading application of this principle is to avoid placingtrading orders right at these obvious round numbers. For example, ifthe trader is trying to buy into a short term market dip in anuptrend, it would make sense to place limit orders just above animportant round number. Because others are trying to buy themarket at the round number, the market may never get there.Traders looking to sell on a bounce should place resting sell ordersjust below round numbers. The opposite would be true whenplacing protective stops on existing positions. As a general rule,avoid placing protective stops at obvious round numbers.Basic Concepts of Trend 65
In other words, protective stops on long positions shouldbe placed below round numbers and on short positions, abovesuch numbers. The tendency for markets to respect round num-bers, and especially the more important round numbers previous-ly referred to, is one of those peculiar market characteristics thatcan prove most helpful in trading and should be kept in mind bythe technically oriented trader.
TRENDLINES
Now that we understand support and resistance, let’s addanother building block to our arsenal of technical tools—thetrendline. (See Figures 4.6a-c.) The basic trendline is one of thesimplest of the technical tools employed by the chartist, but isalso one of the most valuable. An up trendline is a straight linedrawn upward to the right along successive reaction lows asshown by the solid line in Figure 4.6a. A down trendline is drawndownward to the right along successive rally peaks as shown inFigure 4.6b.
Figure 4.6a
Example of an up trend-line. The up trendline isdtawn under the risingreaction lows. A tenta-tive trendline is firstdrawn under two succes-sively higher lows (points1 and 3), but needs athird test to confirm thevalidity of the trendline(point 5).
 66 Chapter 4
 
Figure 4.6bA down trend-line is drawnover the succes-sively lower rallyhighs. The ten-tative downtrendline needstwo points (1and 3) to bedrawn and athird test (5) toconfirm itsvalidity.
 
 
12122195 ("BKX) Phix Kow Bank Index
 
Weekly Bar Chart
 
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a
 
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Figure 4.6c Long term up trendline at work. The up trendline was drawnupward and to the right along the first two reaction lows (see arrows). Thethird low at the start of 1998 bounced right off the rising trendline, therebykeeping the uptrend intact.Basic Concepts of Trend 67
 
Drawing a Trendline
The correct drawing of trendlines is a lot like every other aspect ofcharting and some experimenting with different lines is usuallynecessary to find the correct one. Sometimes a trendline thatlooks correct may have to be redrawn. But there are some usefulguidelines in the search for that correct line.
First of all, there must be evidence of a trend. This meansthat, for an up trendline to be drawn, there must be at least tworeaction lows with the second low higher than the first. Of course,it always takes two points to draw any straight line. In Figure 4.6a,for example, only after prices have begun to move higher frompoint 3 is the chartist reasonably confident that a reaction low hasbeen formed, and only then can a tentative up trendline be drawnunder points 1 and 3.
Some chartists require that the peak at point 2 be penetrat-ed to confirm the uptrend before drawing the trendline. Othersonly require a 50% retracement of wave 2-3, or that prices approachthe top of wave 2. While the criteria may differ, the main point toremember is that the chartist wants to be reasonably sure that areaction low has been formed before identifying a valid reactionlow. Once two ascending lows have been identified, a straight lineis 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 order to confirm thevalidity of a trendline, however, that line should be touched athird time with prices bouncing off of it. Therefore, in Figure 4.6a,the successful test of the up trendline at point 5 confirmed thevalidity of that line. Figure 4.6b shows a downtrend, but the rulesare the same. The successful test of the trendline occurs at point5. To summarize, two points are needed to draw the trendline,and a third point to make it a valid trendline.
How to Use the Trendline
Once the third point has been confirmed and the trend proceedsin its original direction, that trendline becomes very useful in a68 Chapter 4
variety of ways. One of the basic concepts of trend is that a trendin motion will tend to remain in motion. As a corollary to that,once a trend assumes a certain slope or rate of speed, as identifiedby the trendline, it will usually maintain the same slope. Thetrendline then helps not only to determine the extremities of thecorrective phases, but maybe even more importantly, tells uswhen that trend is changing.
In an uptrend, for example, the inevitable corrective dipwill often touch or come very close to the up trendline. Becausethe intent of the trader is to buy dips in an uptrend, that trend-line provides a support boundary under the market that can beused as a buying area. A down trendline can be used as a resis-tance area for selling purposes. (See Figures 4.7a and b.)
As long as the trendline is not violated, it can be used todetermine buying and selling areas. However, at point 9 in Figures4.7a-b, the violation of the trendline signals a trend change, call-ing for liquidation of all positions in the direction of the previoustrend. Very often, the breaking of the trendline is one of the best earlywarnings of a change in trend.
 
Figure 4.7a = Once the up trendline has been established, subsequent dipsnear the line can be used as buying areas. Points 5 and 7 in this example couldhave been used for new or additional longs. The breaking of the trendline atpoint 9 called for liquidation of all longs by signaling a downside trend reversal.Basic Concepts of Trend 69
 
Figure 4.7bPoints 5 and 7 couldhave been used asselling areas. Thebreaking of thetrendline at point 9signaled an upsidetrend reversal.
 
How to Determine the Significanceof a Trendline
Let’s discuss some of the refinements of the trendline. First, whatdetermines the significance of a trendline? The answer to thatquestion is twofold—the longer it has been intact and the number oftimes it has been tested. A trendline that has been successfully test-ed eight times, for example, that has continually demonstrated itsvalidity, is obviously a more significant trendline than one thathas only been touched three times. Also, a trendline that has beenin effect for nine months is of more importance than one that hasbeen in effect for nine weeks or nine days. The more significantthe trendline, the more confidence it inspires and the moreimportant is its penetration.
Trendlines Should Include All Price Action
Trendlines on bar charts should be drawn over or under the entireday’s price range. Some chartists prefer to draw the trendline byconnecting only the closing prices, but that is not the more stan-dard procedure. The closing price may very well be the mostimportant price of the day, but it still represents only a small sam-ple