. Ehlers, MESA and Trading Market Cycles John Wiley & Sons, New York, 1992).CYCLE CHANNEL INDEX 209
 
FIGURE 8-13 The phase angle forms a sawtooth pattern.
 
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—_—Source: John Ehlers, “Cycle Analysis and Intraday Trading,” Technical Analysis of Stocks & Commodities, |, no. 4(February 1993).© 1993 Technical Analysis, Inc. Used with permission.
they will not continue for long periods, and you must recognize them quickly if they are tobe useful; therefore, short-term cycles are found by analyzing only a small amount ofrecent data.
Then how does it help to find a short-term cycle based on a small amount of data, if itis not statistically dependable? In a lateral shift, Ehlers uses the existence of a short-termcycle to tell if prices are in a sideways pattern or trending. Ifa short-term cycle exists, thenthe market trend should be weak. Ehlers has no interest in trading the cycle, which is sur-prising for a cycle expert, but prefers the dependability of the trend. He has, instead,attempted to solve one of the most difficult problems facing the analyst, trying to distin-guish between a trending and sideways market. If a short-term cycle exists, then we cannotrely on the trend, Ehlers develops this method throughout his book.
CYCLE CHANNEL INDEX
A trend-following system that operates for a market with a well-defined cyclic patternshould have specific qualities that do not necessarily exist in a generalized smoothingmodel, To confirm the cyclic turning points, which do not often occur precisely where theyare expected, a standard moving average should be used, rather than an exponentiallysmoothed one. Although exponential smoothing always includes some residual effect ofolder data, the determination ofa cyclic turning point must be limited to data that is nearerto one-fourth of the period, combined with a measure of the relative noise in the series,which may obscure the turn.
These features have been combined by Lambert'’ into a Commodity Cycle Index(CCT), which is calculated as follows:
“Donald R. Lambert, “Commodity Channel Index Tools for Trading Cyclic Trends,” Commodities (1980),reprinted in Technical Analysis of Stocks & Commodities.210 CYCLE ANALYSIS
 
x, — Xi .
cc, =*~ .015MD
where x, = (H, +L, + C,)/3 is the average of the daily high, low, and closeX,= S x, is the moving average over the past NV daysfafoNed
MD= > |x, -x| is the mean deviation over the past N days
infonetNis the number of days selected (less than % cycle)
Because all terms are divided by N, that value has been omitted. In the CCI calcula-tions, the use of .015MD as a divisor scales the result so that 70% to 80% of the values fallwithin a +100 to —100 channel. The rules for using the CCI state that a value greater than+100 indicates a cyclic turn upward; a value lower than —100 defines a turn downward.Improvements in timing rest in the selection of N as short as possible but with a mean devi-ation calculation that is a consistent representation of the noise. The CCI concept of iden-tifying cyclic turns is good because of the substantial latitude in the variance of peaks andvalleys, even with regular cycles. :
PHASING
One of the most interesting applications of the cyclic element of a time series is presentedby J.M. Hurst in The Profit Magic of Stock Transaction Timing (Prentice-Hall); it is theDhasing or synchronization of a moving average to represent cycles. This section will high-light some of the concepts and present a simplified example of the method. It is alreadyknown that to isolate the cycle from the other elements, the trending and seasonal factorsshould be subtracted, reducing the resulting series to its cyclic and chance parts. In manycases, the seasonal and cyclic components are similar, but the trend is unique. Hurst treatsthe cyclic component as the dominant component of price movement and uses a movingaverage in a unique way to identify the combined trend-cycle.
The system can be visualized as measuring the oscillation about a straight-line approx-imation of the trend (centered line), anticipating equal moves above and below. Priceshave many long- and short-term trends, depending on the interval of analysis. Because thistechnique was originally applied to stocks, most of the examples used by Hurst are long-term trends expressed in weeks, For commodities the same technique could be used byapplying the nearest futures contract on a continuous basis.
As a simple example of the concept, choose a moving average of medium length for thetrending component. The /ull-span moving average may be selected by-averaging the dis-tance between the tops on a price chart. The baif-span moving average is then equal to halfthe days used in the full-span average.
The problem with using moving averages is that they aways lag. A 40-day moving aver-age is always 20 days behind the price movement. The current average is plotted under themost recent price, although it actually represents the price pattern if the plot were laggedby one-half the value of the average. This method applies a process called phasing, whichaligns the tops and bottoms of the moving average with the corresponding tops and bot-toms of the price movement. To phase the full- and half&span moving averages, lag eachplot by half the days in the average; this causes the curve to overlay the prices (Figure8-14). Fhen project the phased full- and half-span moving averages until they cross. A lineor curve connecting two or more of the most recent intersections will be the major trend-line. The more points used, the more complicated the regression formula for calculatingPHASING - 211
 
the trend; Chapter 3 discusses a variety of linear and nonlinear techniques for finding thebest fit for these intersections. Once the trendline is calculated, it is projected as the cen-ter of the next price cycle.
With the trend identified and projected, the next step is to reflect the cycle about thetrend. When the phased half-span average turns down at point A (Figure 8-15), measurethe greatest distance D of the actual prices above the projected trendline. The system thenanticipates the actual price crossing the trendline at point X and declining an equal dis-tance D below the projected trendline. Once the projected crossing becomes an actualcrossing, the distance D can be measured exactly and the price objective firmed. Rules forusing this technique can be listed as follows:
1. Calculate the full-span moving average for the selected number of days; lag theplot by half the days. If the full-span moving average uses F days, the value of theaverage is calculated at t — F/2, where t is the current day. Call this phased pointPH,.
2. The half-span moving average is calculated for H days and plotted at t - H/2 + PH,.
3. Record the points where the two phased averages PH; and PF; cross and call these
points X,, X,-1,.-.-4. Find the trend by performing a linear regression on the crossing points X,,,X,-1,-... Ifa straight line, then ¥;= @ + bX;.
 
FIGURE 8-14 Phasing.
 
Lag Plot_ 20 Days
 
 
0 5 10 1s Xe 35 30 3s 40DAYS -CYCLE ANALYSIS
 
 
FIGURE 8-15 Finding the target price.
 
  
Moving Average Projected Cycle
     
  
       
  
  
You e + dXc cLastCrossing X Say Ne Proncied Crossing——— _ TX“Be Fi bos Yr" YoProjected Trend i waFull-Span Ypeat OX, pMoving Average 'B Price Objective(Target)
 
5. Record the highest (or lowest) values of the price since the last crossing, X,.
6. Calculate the projection of the halfspan by creating a straight line from the high-est (or lowest) half-span value since the last crossing (A) to the last calculated half-span value. This equation will be ¥;=c+dX¢.
7. Find the point at which the projected trendline crosses the projected cyclic line bysetting the equations equal to one another and solving for X and ¥ At the point ofcrossing (X;, Y;) = (Xc, %), giving two equations in two unknowns, which is easilysolvable (X is time in days; Y is price).
8. If the half-span is moving down, the maximum price reached by the commoditysince the last crossing is subtracted from the ¥ coordinate of the projected cross-ing. This distance D is subtracted again from.the Y coordinate to determine theprice objective, If the half-span is moving up, the price objective uses the minimumprice and reflects the distance above the projected crossing. It should be notedthat this calculation of distance is simplified because the trend is established by astraight line; for nonlinear fits, the measurement of D will be more complicated.
9. Recalculate the moving averages, the half-span projection (6), the projected cross-ing (7), and price objective (8) each day until the actual crossing occurs. At thattime D is fixed.
10. Follow the trading rules: ‘
a. Enter a new long position when the half-span moving average turns up; coverany existing short positions regardless of the price objective.
b. Enter a new short position when the half-span moving average turns down;close out any long positions.
c. Close out both long and short positions if the price objective is reached. An al-lowable error factor is considered as 10% of the height of the full cycle (lowestto highest point).
This approach to cycles should be studied carefully as an example of a complex prob-
lem solved using elementary mathematics. There are many techniques for determiningtrends and a number of seasonally oriented systems, but a.cyclic approach is rare. WhereasHurst’s explanation is more complete and more sophisticated, the interpretation pre-sented in this section should be considered only a reasonable approximation. 
Charting
ries and complex formulas may ultimately be successful, but the loss of perspec-
tive is rarely corrected without a simple chart. We should remember the investorwho, anxious after a long technical presentation by a research analyst, could only blurtout, “But is it going up or down?” Even the most sophisticated market strategies mustcapture the obvious trends or countertrends. Before any trading method is used, thepast buy and sell signals should be plotted on a chart. Those signals should appear at log-ical points; otherwise, the basis of the strategy or the testing method should be ques-tioned.
+ Through the mid-1980s technical analysis was considered chart interpretation. In theequities industry that perception is still strong. Most traders begin as chartists, and manyreturn to it or use it along with their other methods. William L. Jiler, a great trader andfounder of Commodity Research Bureau, wrote:
Ne can a picture be more valuable than in price forecasting. Elaborate theo-
One of the most significant and intriguing concepts derived from intensive chartstudies by this writer is that of characterization, or habit. Generally speaking,charts of the same commodity tend to have similar pattern sequences whichmay be different from those of another commodity. In other words, charts ofone particular commodity may appear to have an identity or a character pecu-liar to that commodity. For example, cotton charts display many round tops andbottoms, and even a series of these constructions, which are seldom observedin soybeans and wheat. The examination of soybean charts over the years re-veals that triangles are especially favored. Head and shoulders formationsabound throughout the wheat charts. All commodities seem to favor certain be-havior patterns."
In addition to Jiler’s observation, the cattle market is recognized as also having theunusual occurrence of “V” bottoms. Both the silver and pork belly markets have tenden-cies to look very similar, with long periods of sideways movement and short-lived, violentprice shocks, where prices leap rather than trend to a new level. The financial markets haveequally unique personalities. The S&P traditionally makes new highs, then immediatelyfalls back; it has fast, short-lived drops and slower, steady gains. Currencies show interme-diate trends bounded by noticeable major stopping levels, while long-term interest rateshave long-term direction. _ ~
Charting remains a most popular and practical form for evaluating commodity pricemovement, and numerous works have been written on methods of interpretation. Thischapter will summarize some of the accepted approaches to charting, and then consideradvanced concepts of both standard charting methods and systems designed to take advan-tage of behavioral patterns found in charts. Some conclusions will be drawn as to what ismost likely toswork and why.
* William L. Jiler, How Charts Are Used in Commodity Price Forecasting (Commodity Research Publications, NewYork, 1977).214 CHARTING
 
FINDING CONSISTENT PATTERNS
A price chart is often considered a representation of human behavior. The goal of anychart analyst is to find consistent, reliable, and logical patterns that predict price move-ment. In the classic approaches to charting, there are consolidation forms, trend chan-nels, top-and-bottom formations, and a multitude of other patterns that can only becreated by the repeated action of large groups of people in similar circumstances or withsimilar objectives. As of this date, quantitative studies relating the psychology of behaviorto the reliability of chart formations have not been reliable. Traditional trading techniquesfound in the most popular stocks and commodities literature may themselves be thecause of the repeated patterns. Novice speculators approach the problem with greatenthusiasm and often some rigidity in an effort to stick to the rules. They will sell doubleand triple tops, buy breakouts, and generally do everything to propagate the standard for-mations. In that sense, it is wise to know the most popular and well-read techniques andact accordingly.
Speculators have many habits which, taken as a whole, can be used to interpret chartsand help trading. The typical screen trader (not on the exchange floor) will place an orderat an even number, from 5¢ to $1.00 per bushel in the grains, 10 to 50 points in otherproducts. This pattern far outweighs the number of orders entering the market to buy atodd numbers, for example the S&P at 863.50 rather than 863.35 or bonds at 105 16/32instead of 105 19/32. The public is also known to enter into the bull markets always at thewrong time. When the major media, such as television news, syndicated newspapers, andradio, carry stories of outrageous prices in cattle, sugar, or coffee, the public enters in whatWD. Gann calls the grand rush, causing the final runaway move before the collapse; thisbehavior is easily identifiable on a chart. Gann also talks of lost motion, the effect ofmomentum that carries prices slightly past its goal. A common notion of the professionaltrader who is close to the market is that a large move may carry 10% over its objective. Adownward swing in the U.S. dollar/JJapanese yen from 1.2000 to a support level of 1.1000could overshoot the bottom by .0100 without being considered significant.
The behavioral aspects of prices appear rational. In the great bull markets, therepeated price patterns and variations from chance movement are indications of the effectsof mass psychology. The greatest single source of information on this topic is Mackay’sExtraordinary Popular Delusions and the Madness of Crowds, originally published in1841.7 In the preface to the edition of 1852 the author says:
We find that whole communities suddenly fix their minds on one object, and gomad in its pursuit; that millions of people become simultaneously impressed withone delusion. ...
In 1975, sugar was being rationed in supermarkets at the highest price ever known.The public was so concerned that there would not be enough at any price that they wouldbuy (and horde) as much as possible. This extreme case of public demand coincided withthe peak prices, and shortly afterward the public found itself with an abundant supply ofhigh-priced sugar in a rapidly declining market. The world stock markets are often the tar-get of acts of mass psychology. Many have taken their rurn reaching incredible héights, onlyto drop suddenly at a time when buyers are most confident, to start the long climb upagain. It should not be difficult to understand why contrary thinking has developed.
Charting is a broad topic taken to great detail; the chart paper itself and its scaling aresources of controversy. A standard bar chart (or line chart) representing highs and lows canbe plotted for daily, weekly, or monthly intervals to smooth out the price movement overtime. The use of large increments representing price levels will reduce the volatile appear-
? Reprinted in 1995 by John Wiley & Sons, Inc.INTERPRETING THE BAR’CHART 215eoance of price fluctuations. Bar charts have been drawn on logarithmic and exponentialscales, where the significance of greater volatility at higher price levels is put into proportion,with the quieter movement in the low ranges by using percentage changes. Each variationgives the chartist a unique representation of price action. The shape of the box and its ratioof height/width will alter subsequent interpretations based on angles. Standard techniquesapplied to bar graphs, point-and-figure charts, and other representations use support andresistance trendlines, frequently measured at 45-degree angles (and at various other anglesin more complex theories). Selection of the charting paper may have a major effect on theresults, This chapter will use daily price charts and square boxes unless otherwise noted.
It may be a concern to today’s chartist that the principles and rules that govern chartinterpretations were based on the early stock market, using averages instead of individualcontracts. This will be discussed in the next section. For now, refer to Edwards and Magee,who said that the similarity of an organized exchange trading, “anything whose marketvalue is determined solely by the free interplay of supply and demand,” will form the samegraphic representation. They continued to say that the aims and psychology of speculatorsin either a stock or commodity environment would be essentially the same; the effect ofpostwar government regulations have caused a “more orderly” market in which these samecharting techniques can be used.‘
INTERPRETING THE BAR CHART
The bar chart, also called the line chart, became known through the theories of Charles H.Dow, who expressed them in the editorials of the Wall Street Journal. Dow first formulatedhis ideas in 1897 when he created the stock averages for the purpose of evaluating themovements of stock groups. After Dow’s death in 1902, William P. Hamilton succeeded himand continued the development of his work into the theory that is known today. Thosewho have used charts extensively and understand their weak and strong points might beinterested in just how far our acceptance has come. In the 1920s, a New York newspaperwas reported to have written:
One leading banker deplores the growing use of charts by professional stocktraders and customers’ men, who, he says, are causing unwarranted market de-clines by purely mechanical interpretation of a meaningless set of lines. It is im-possible, he contends, to figure values by plotting prices actually based on supplyand demand; but, he adds, if too many persons play with the same set of charts,they tend to create the very unbalanced supply and demand which upsets markettrends. In his opinion, all charts should be confiscated, piled at the intersection ofBroad and Wall and burned with much shouting and rejoicing.*
This same newspaper may have repeated this idea applied to program trading after thestock market plunge in October 1987. Nevertheless, charting has become part of the finan-cial industry, whether the analyst is interested in the fundamentals of supply and demandor pure price movement. The earliest authoritative works on chart analysis are long out ofprint, but the essential material has been recounted in newer publications. If, however, acopy should cross your path, read the original Dow Theory by Robert Rhea;° most of all,read Richard W. Schabacker’s outstanding work Stock Market Theory and Practice, whichis probably the basis for most subsequent texts on the use of the stock market for invest-
5 RW. Schabacker, Stock Market Theory and Practice (Forbes, New York, 1930, pp. 595-600).
‘Robert D. Edwards and John Magee, Technical Analysis of Stock Trends (john Magee, Springfield, MA, 1948,Chapter 16). _
5 Richard D, Wyckoff, Stock Market Technique, Number One (Wyckoff, New York, 1933, p. 105).© Robert Rhea, Dow Theory (Vail-Ballou, Binghamton, NY, 1932).216 CHARTING
 
ment or speculation. The most available book that is both comprehensive and well writtenis Technical Analysis of Stock Trends by Robert D. Edwards and John Magee. It is confinedentirely to chart analysis with related management implications and a small section oncommodities. For the reader who prefers concise information with few examples, themonograph by WL. Jiler, Forecasting Commodity Prices with Vertical Line Charts, and acomplementary piece, Volume and Open Interest, A Key to Commodity Price Forecasting,can still be found.” A valuable recent addition is Jack Schwager’s, Schwager on Futures:Technical Analysis (Wiley, 1996), the first of a three-volume set.
The Dow Theory
In its basic form, the Dow theory is still the foundation of chart interpretation and appliesequally to stocks, financial markets, commodities, and the wide variety of vehicles used totrade them. Its major premise is that averages remove a large amount of extraneous pricemotion; therefore, Dow’s original work applied exclusively to averages and not to individ-ual stocks. In fact, Dow’s Industrial, Utility, and Transportation averages have survived thetest of time. The difficulty with interpreting stock movement is in the thinness of a specificissue especially in the early part of the twentieth century; its fixed number of shares andlight volume made the movement of one stock an unreliable indicator of an economicturn. Taken in total, it would be improbable to move the average by the manipulation of asingle issue; hence, the averages become the subject of analysis. Commodities, especiallythe financial and index markets, differ from stocks in their enormous volume, as demon-strated by the Eurodollars, which can trade exceptionally high volume with only the slight-est price movement. In futures, trading can be limited to one primary contract with littledistortion because of constant massive arbitrage between futures and cash, and betweenone bank and another, especially in the interest rate and currency markets. The possibilityof one trader influencing the U.S. bond market (other than the Chairman of the FederalReserve) for more than a few seconds is remote to the point of no concern. When workingin financial markets a single product is often given the same significance as a sector in thestock market when constructing a portfolio or index, yet in the footsteps of Dow, a groupof international interest rates, with similar maturities, or a U.S. dollar index, can still be avaluable substitute for a single market. -
The Dow theory defines price motion, as represented by the average, in three distinctprimary, secondary, and minor trends. These elements have often been compared with thetide, the wave, and the ripple. The primary trend denotes the main move that exceeds 20%of the original price; the secondary trend is an adjustment or correction, and the minormovements are day-to-day fluctuations. The theory emphasizes the main move. As Angassaid: “Be simple. Take the grand view.” It is easier to identify the dominant trend than toworry about every change in direction.
Accumulation and distribution are the beginning phases of a bull or bear market.Accumulation is the period in which the insiders begin to acquire a long position in antic-ipation of a bull move. In charting, this is traditionally seen as a wide formation at a lowprice with increasing open interest and erratic peaks in volume representing large pur-chases. The distribution phase serves the same function for anticipated bear moves.
A unique part of the original Dow theory that prevents it from being applied to com-modities markets is the principle of confirmation, requiring that a signal be produced bymore than one average. There has been some criticism with regard to the significance ofanindustrial group being confirmed by a rail, but the concept seems sound. Ifthe purpose of
” Fwo other works worth studying are Gerald Appel, Winning Market Systems: 83 Ways to Beat the Market (Sig-nalert, Great Neck, NY, 1974), and Gerald Appel and Martin E. Zweig, New Directions in Technical Analysis (Sig-nalert, Great Neck, NY, 1976).CHART FORMATIONS 217
 
the Dow theory is to identify major trends in the economy, it is unlikely that the average ofone stock group would be going up and the other group moving down in a well-definedinflationary or deflationary period. In the same way, one would not expect the price ofcorn to increase and the price of wheat to decrease in absolute terms. A period of inflationshould uniformly affect stocks and commodities; any items varying from the total patternshould be explained on an individual basis.
The relationship of the number of shares or contracts traded to the development of aprice move is characterized by saying that “volume expands with the trend.” Whether a bullor bear market, activity increases as the trend becomes clear. In futures, the open interesthas been treated in the same manner, with increased open interest, especially during theaccumulation and distribution phases, a sign of a new move forming.
The Dow theory has other points that have been incorporated into chart interpreta-tion. The exclusive use of closing prices is important for two reasons: (1) they are mostclosely followed by the typical speculator, and (2) they discount the effects of any positionstaken by floor traders who are day-trading. Support and resistance lines were introducedas a substitute for the secondary move, which may have been difficult to define. Lastly, thetheory expressed a trading philosophy by stating that a trend should be assumed to beintact until a reversal occurred.
CHART FORMATIONS
Chart analysis applies straight lines and geometric formations extensively. They can be clas-sified into broader groups of trendlines and channels, accumulation and distribution, andother patterns. In addition, chart formations can apply to major or minor price changesand to different time frames.
Trendlines -
The trendline remains the most popular and readily recognized tool of chart analysis. Itcan be any of the following:
A support line is drawn to connect the bottom points of a price move. A horizontalsupport line is extremely common and represents a firm price level that has withheldmarket penetration. It may be the most significant of all chart lines.
A resistance line is drawn across the price peaks of a sustained move, or a horizontalresistance line representing the fixed level that resists upward movement. Resistancelines are not normally as clear as support lines because they are associated with highervolatility, which causes erratic price movement.
A channel is the area between parallel support and resistance lines that serves to con-tain a sustained price move. When the support and resistance lines are relatively hori-zontal, or sideways, the channel is called a trading range.
A bullish support line would then be a rising line drawn across the lowest points of aprice move, and a bearish resistance line is a declining line drawn across the highestpeaks of a price move.
Formations for Accumulation and Distribution
Most of the effort in charting goes into the identification of tops and bottoms. Becausemany of these formations unfold over fairly long periods, they have been called accumula-tion at the bottom, where typical stock investors slowly buy into their position, and distri-bution at the top, where the invested positions are sold off. The most popular of theseformations are:218 CHARTING
 
Head-and-shoulders bottom and top
Common rounded upward or downward turn
Triangular bottom and top of an ascending, descending, or symmetric shape, such as
a triangle, flag, or pennant
Ascending bottom and top
“v"-bottom (a “V”-top is usually referred to as a spike)
Double bottom and top
Complex bottom and top, including a triple bottom or top, or a combination of other
formations
Broadening bottom and top
Most of these patterns are self-explanatory and are covered in detail in many booksdevoted entirely to the topic. In addition to the classic by Edwards and Magee and themonograph by Jiler, the reader can find considerable value in John Murphy’s “Bar Chart-ing” in Kaufman, Handbook of Futures Markets,* and more recently Schwager on Futures:Technical Analysis.’ Instead of giving examples of these formations, we will look at themin the context of trading rules.
Individual Patterns
In addition to the broader patterns noted above, there are specific situations of short dura-tion that have been noted by the chartist, including:
GapsSpikesReversal daysThrust daysCups and capsThese will be covered in the following sections.
Major and Minor Formations .
Throughout the study of charting, it is important to remember that the same patterns willappear in short- as well as long-term charts. An upward trendline can be drawn across thebottom of a price move that only began last week; it can represent a sustained 3-year trendin the financial markets, or a 6-month move in coffee. In general, the longer the time inter-val, the more significant the formation. Contract highs and lows, well-defined tradingranges, trendlines using weekly charts, and head-and-shoulder formations are carefullywatched by traders. Obscure patterns and new formations are not of interest to mostchartists, and without the support of the traders, conclusions drawn from those formationshave no substance. The basic charting course also includes interpretation of volume andOpen interest and a variety of rules for using the formations.
BASIC TRADING RULES “
The simplest formations to recognize are the most commonly used and most important:horizontal support and resistance lines, bullish and bearish support and resistance lines,and channels. Proper use of these basic lines is essential for identifying the overall direc-
* arthur Sklarew, Techniques of a Professional Commodity Chart Analyst (Commodity Research Bureau, NewYork, 1980), and John Murphy, “Bar Charting” in Handbook of Futures Markets, Perry J, Kaufman (ed.) JohnWiley & Sons, New York, 1984).
° Jack D. Schwager, Schwager on Futures: Technical Analysis (John Wiley & Sons, New York, 1996).BASIC TRADING RULES. 219
 
tion of the market and how it gets there. An understanding of these patterns will be help-ful to computer-oriented analysts, many of whose techniques have been modeled afterchart formation. More complex formations are likely to enhance good performance butcannot compensate for poor trend identification.
Once the support and resistance lines have been drawn, a price penetration of thoselines creates the basic trend signal (Figure 9-14). The bullish support line defines the upwardtrend, and the bearish resistance line denotes the downward one. For long-term charts andmajor trends this is often sufficient, but frequent small penetrations of both long- and short-term trendlines can be avoided by placing a band around both lines (Figure 9-16). A shortsignal occurs when both the trendline and the band have been penetrated. Because of thebasic charting rule—*Once broken, a resistance level becomes a support level and a supportlevel becomes a resistance level”—the original trendline (or a trendline plus and minus aband) can be used as a stop-loss. If prices penetrate the stop-loss point, then return to theoriginal formation; there has been a false breakout and the original trendlines are still valid.
A Classic Dilemma
The use of bands around a trendline is more popular than the use of the trendline alonebecause price movement is not clean. Larger bands produce more reliable trend signals;
eS
FIGURE 9-1 Basic trading rules