is more sophisticated, because itattempts to measure the quality of a price movement and then takea position that may be opposite the current trend. The other typesof analysis try to spot existing trends or certain formations that arereliable harbingers of future price activity.TECHNICAL ANALYSIS SIGNALSAND CHART FORMATIONS
There are 18 basic technical analysis signals and chart formationsthat you should be aware of: trend lines, rounded bottoms, consolidations, tops, bottoms, support, resistance, retracements, reversals,
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head and shoulders, continuation formations, triangles, coils, boxes,flags, pennants, diamonds, and moving averages.THE TREND LINE
The most common technical analysis tool is the trend line. Pricestend to follow straight lines. They almost cling to them. If theybounce off a line, they are drawn back to it. There are sound psychological reasons why prices trend.A trend line is a line drawn between at least two points on aprice chart. Uptrend lines (see Figure 6.3) should be drawn so theyconnect lows and are drawn below prices. Downtrend lines (see Figure 6.4) connect highs and are drawn above prices. Sideways trendlines (see Figure 6.5) are drawn below prices and connect lows.
F I G U R E
6.3
Uptrend Formation
The uptrend formation is probably the most common and most followed ofchart formations. Traders using this trend believe prices will continue toincrease.
Chart courtesy of “Pocket Charts.”
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6.4
Downtrend Formation
Up, down, and sideways trends are usually drawn by connecting highs or lows.Trends tend to continue until something upsets the supply-demand equation.
Chart courtesy of “Pocket Charts.”
Why Do Prices Cling to Straight Lines?It is simply human nature. A trader will resist paying more for acommodity than others are willing to pay unless there is some reason to believe it will continue to increase in price. The converse isequally true.Therefore, if a price is going up, traders will watch the trend.As long as it moves higher, buyers will continue to buy. If it increasesa little too fast, buyers hold back and the price returns to the trendline. The more buying (volume) taking place, the more confidencetraders have that prices will continue to rise.Everyone is more comfortable when others are behaving thesame. This is referred to as herd psychology. Sometimes the herd psy-
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6.5
Sideways Trend
Traders commonly say, “The trend is your friend.” This simply means prices willcontinue in the established direction until there is a reason for change ofdirection.
Chart courtesy of “Pocket Charts.”
chology can be quantified through the measurement of volume andopen interest. Volume is the total number of contracts traded in aday. Open interest is the number of contracts outstanding at the endof a trading day.Other human psychological tendencies also come into play.The inventory manager, who is responsible for buying a commodityfor a company or a country, increases purchases as prices go up, outof fear that prices will be even higher in the future. This increasesconsumption.The person who owns the commodity holds out for higherprices when prices are seen to be increasing. This reduces the supply. And the uptrend continues.
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The Law of Price-Trend InertiaHuman resistance to change has a strong impact on trends. Nobodywants to be the first one to go against the crowd. This brings usto rule 1. When a commodity is found to be following a trend, it islikely to continue along on that trend. Spotting trends is simply amatter of drawing trend lines on price charts. The key to technicalanalysis is recognizing which trends are significant and reliable.Technical analysis is more of an art than a science.Rule 2 says the longer the term of the chart, the more reliablethe trend line. A trend line on a monthly price chart is more reliableand significant than one on a weekly chart. One on a weekly is better than one on a daily, and a daily means more than an hourly. Thereason is that the longer something lasts, the more comfortable itseems, and the less likely we are to want to change it.
How Do You Confirm a Trend Is a Trend?One of the answers is volume. The more trades behind a price move,the stronger the conviction there is in the marketplace of the trend.This is rule 3. The greater the volume, the greater the significance ofa price trend.Volume also tells you when traders think prices are movingtoo far or too fast. In these two situations, volume decreases andprices reverse. For example, in the normal uptrending market, whenprices move too far above the trend line, volume will decrease until prices return to the trend line. Conversely, in a downtrend, thevolume is usually greater when prices are falling than when they arerallying. These are rules 4 and 5.Markets are like rattlesnakes. They make a noise before theybite. Each time an established trend line is penetrated, it’s a warning that the market may reverse. This is rule 6.Substantial changes in volume are another rattle from a market that it is about to reverse. Rule 7 notes that if the market is in anuptrend, volume usually decreases before a reversal. If it is a downtrending market, rule 8 notes that volume usually increases beforeit reverses. The reason is that prices can fall from their own weight,but they need constantly increasing buying activity to trend higher.The first sign to look for when a market is changing direc-
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tion is a violation of the trend line. A small dip below an uptrenddoesn’t necessarily mean the trend has changed, but it is a warning (rule 9).
Other FormationsThere are several different types of trend lines besides the basic up,down, and sideways. There is the fan formation, for example (seeFigure 6.6). It is a series of trend lines extending from the same point,but drawn at different angles.The fan trend-line formation develops when an establishedtrend line is broken, but the price continues to move in the same direction, forming a new trend line. This can happen two or three
F I G U R E
6.6
Fan Formation
As prices reach a peak (high or low), the trend line becomes increasinglysteeper. This is a warning to experienced traders that a trend change isimminent.
Chart courtesy of “Pocket Charts.”
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times, and rarely four or more times (rule 10). After the third, be veryalert.It also occurs when prices heat up. Each successive trend linebecomes steeper and steeper as a market heads for a blow-off top.The internal trend line is an interesting formation. It developsout of a broken uptrend line. After the uptrend is broken, the market retraces, and eventually the highs are attracted to the bottom ofthe old trend line. This is also an example of the “pullback” effect.
What Does All This Mean to a Trader?Trend lines are your basic signals for whether you should be on thelong or the short side of the markets. Additionally, they tell you howmuch conviction traders have in their positions. They warn youwhen investors are losing faith in their positions. They tell the contrary trader what the herd thinks about where prices are headed.The trend can be your friend—if you learn how to read it. Alwaysanalyze it in light of volume and open interest. (There’s more on volume and open interest later in this chapter).A CHARTIST’S DREAM FORMATION—THE ROUNDED BOTTOM
The chart formation known as the rounded bottom (see Figure 6.7)is a chartist’s dream, because it is easy to recognize, it is reliable,and it alerts you to an upcoming long-term price move. Most important of all, this formation gives you time to make your decision.If you miss taking advantage of a rounded bottom, it is your ownfault.The formation starts with prices gradually moving down. Theybottom. Then they gradually increase. Like any meaningful chartformation, there are some good psychological reasons behind it. Arounded bottom develops out of an increasing oversupply situation. As supplies of a commodity become plentiful, inventory managers (buyers) purchase from hand to mouth, believing the commodity will become less expensive tomorrow.Volume on the exchanges for the commodity drops off, astraders wait to see if the movement is a major bear market or just aretracement where the market reacts to the main trend by retracing
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6.7
Rounded Bottom
The rounded-bottom formation is a harbinger of a major uptrend in prices.It often takes a long time in developing.
Chart courtesy of “Pocket Charts.”
itself. The supply-demand equation becomes balanced, and a long,flat bottom develops.
Great Bull Markets Are Childrenof OverSupply!Once the price stabilizes at a low price, the users of the commoditybegin to take advantage and increase their usage. Demand builds.Inventory managers sense future price increases and add to the demand by laying away inventory.Traders anticipate increased activity and begin bidding pricesup at the exchanges. The volume of trades mirrors the price activity. A bull market often erupts from the rounded-bottom formation.
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PERIODS OF CONSOLIDATION
A variation of the rounded formations is horizontal channels or flatformations. These occur when a commodity or index has developeda base for a major move in the future.They appear on the price charts as long sideways patterns.Prices trade in a very narrow range. Volume is low because tradersfeel that the market has little potential. Speculators are bored bythese markets. They become flat or stagnant.This formation can develop at major tops, major bottoms, or intermediate formations, occurring somewhere between major highsand lows. This formation is often a harbinger of a major move,which could just as easily be up as down. Some people describethem as trading plateaus. The longs and the shorts are neutral untilsomething positive or negative heats the market up. At that point, amajor move often occurs.
SPIKED TOPS AND BOTTOMS
The spiked-top or spiked-bottom formation is as unpredictable asthe rounded bottom is predictable. It strikes without warning. It isalmost as if all the traders in a given market got together and decided to sell or buy at one time.In the spiked-bottom formation (see Figure 6.8) the price ofa commodity drops sharply and hits a point substantially belowwhere the fall began. It then stops and begins moving up sharply.The turnaround usually is done in a single day of trading, althoughthe decline can occur over a few days. After the bottom, the climbup continues for some time. You must draw a steep trend line alongthe downtrend portion of the formation. You cannot be sure the bottom is in place until this trend line is broken.Take care that you don’t get whipsawed. This occurs when youprematurely reverse your position and move from long to short orshort to long before you are sure the trend has changed. This canhappen with spiked moves. The market moves sharply down andthen pauses, only to plunge even deeper.The psychology behind spike formations is the same herd psychology that causes cattle to stampede. To begin with, the market isnervous about what to expect. Often it has recently experienced
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6.8
Spiked-Bottom Formations
Spiked tops and bottoms can strike fear into the most experienced traders.They occur without warning and result in a major trend change.
Chart courtesy of “Pocket Charts.”
some totally unexpected news. Everyone’s confidence in analysis isat a low. No one really believes anyone knows what will happen next.Then, out of nowhere, more very grim unexpected news mayoccur. Traders sell the news, panicking and rushing to get out oftheir longs. The market makes a spiked move downward while themarket learns the true facts, which may be nowhere near as devastating as the news seemed to be. Traders begin buying the facts, andthe market recovers.
Multiple Tops and BottomsDouble and triple tops and bottoms are among the most common,yet most deceptive, of chart formations.
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F I G U R E
6.9
Double-Top Formation
Double-top formations are sometimes referred to as “M” formations. Theysignal a change in trend. Warning: They can become triple tops, which canwhipsaw traders.
Chart courtesy of “Pocket Charts.”
The double top resembles the letter “M” (see Figure 6.9). Pricesrise sharply to a point, fall back about half as far, and rise again tothe previous point. Then they decline beyond the point where theformation began. The double bottom looks like the letter “W” andis the reverse of the double top.These formations are deceptive, because it is very common forcommodities to trend up and down. Inexperienced chartists beginseeing M and W formations on every chart. So many of these arefalse signals.As well, it is nearly impossible to definitely call a double top orbottom until the reversal in trend has become pronounced andprices have moved below the initial starting point. To confirm an M
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or W formation, prices must fall or rise, respectively, beyond the vertex that is between the double top or bottom. By this time, the formation is complete, and a good deal of the move and opportunityhas been missed.Lastly, the move could be a triple top or bottom. If you act whenit is only a double, you could be whipsawed.The normal pattern for volume shows increases around thepeaks. But again, this is not reliable. Studies have shown a lot ofvariation in volume.SUPPORT AND RESISTANCE AREAS
Have you ever watched a commodity move up or down in what canbe described as a stair-step movement? The commodity, for example, moves up 10 or 15 points, consolidates for a few days, and thenmoves up again.Or have you ever observed a bull market move up to a certainpoint and then stop? Or watched a commodity retrace, after a bullmove, to a level it had been previously trading?These are often examples of support and resistance levels. (SeeFigure 6.10.) A support level is a price or price range at which youcan expect increased demand for the commodity. For example, acommodity drops in price until it hits a point where traders or inventory managers (buyers for the users of that commodity) can’t resist buying.One way to detect this activity is by watching volume. As theprice of a commodity decreases, it is common to see the volume decrease. There simply isn’t any buying activity to bolster prices, sothey fall by their own weight.When the commodity reaches a level that is attractive to buyers, volume increases as they take advantage of the “bargains.”Prices trade sideways or rebound slightly on the charts. This becomes a support level.Resistance levels are just the opposite. They are price levelswhere you can expect a lot of selling. Prices reach a range wheretraders no longer see the potential for further increases. Prices consolidate or retrace to lower levels.Changes in volume and open interest alert you to resistancelevels. Therefore, if volume, open interest, and prices are all down,
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F I G U R E 6.10
Support and Resistance Levels
These are pricing levels where the majority of traders actively trading thinkprices have become too high (resistance) or too low (support). Therefore, pricemoves stall.
Chart courtesy of “Pocket Charts.”
you know traders are closing out their long positions. For whatever reason, a resistance level is created on the price charts.Serious technical traders study the long-range charts lookingfor these areas of support and resistance. They know that, as mentioned earlier, when it comes to technical analysis, history repeatsitself.By knowing where prices are likely to stall during a bull moveor likely to find support in a decline, technicians time their trading.The information gives them clues about when to enter or exit markets, where to place protective stop orders, and what the size andlength of anticipated moves will be.Another interesting technical phenomenon you’ll notice as you
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study charts is that previous resistance levels often become supportlevels, and vice versa. For example, a commodity breaks through aresistance level based on some bullish news. Once the move is exhausted, it retraces to find support at the level that previously hadbeen the resistance level to the initial bull move.RETRACEMENTS
A retracement (see Figure 6.11) is a market reaction to the maintrend. If the main trend is up, the market may often decrease or retrace the ground it just covered.Always keep in mind that there are good psychological reasonsfor every chart movement. When traders think a market has movedtoo far or too fast, many will take their profits and exit the markets.F I G U R E
6.11
Retracements
Prices move in uneven, stair-stepping patterns. It’s common for them to movehigher and then retrace before moving higher again.
Chart courtesy of “Pocket Charts.”
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Others short the market because they feel it is unstable. This causesa retracement.But how much of a retracement will occur? How far down orup will the market go? Retracements often pull back or rally to areas of support or resistance, respectively. It is also common for retracements to occur in calculable mathematical proportions.The first step is to calculate the distance from important highsto important lows. Next, you analyze how the particular marketpreviously performed under similar circumstances.What you learn is that most markets often have repetitive retracement patterns. Market analysts accept retracements of 33, 50,or 66 percent as most common. This means that a market thatbegins to retrace will probably retrace 33, 50, or 66 percent of anamount equal to the distance between the previous significant highand low.Again, you use this information as a timing device, or to helpyou select a point where you will take your profits, or reenter themarket, or buy or sell an option.KEY REVERSALS, ISLAND REVERSALS,CONTINENT REVERSALS
Key reversals can occur at either market tops or bottoms (see Figure6.12). They are very reliable indicators that the current market trendis likely to reverse for an undetermined period of time.To understand how one takes shape on the charts, look for keyreversals when a market is in a steep uptrend or downtrend. Next,see if the trading range widens. A new high or low is often made.The market closes near the high in the case of a top or near the lowin the case of a bottom.On the following day’s trading or the key reversal day, pricesmove higher than the previous day’s high and lower than the previous day’s low, closing near the low of the day for a key reversaltop. This reversal is more definitive if accompanied by high volume,sometimes a record high volume, and new contract or all-timehighs. An opposite pattern occurs for key reversal bottoms, againon high volume.An island reversal is similar to a key reversal, but usually involves a few more trading days and requires a gap at either side of
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6.12
Key Reversal Formations
Key reversals can occur at the top or bottom of a market move. They signal amajor change in the direction of the trend.
Chart courtesy of “Pocket Charts.”
the island formation. Typically, the gaps are at approximately thesame price level.The continent reversal is identical to the island reversal exceptthat it may take weeks or even months to form.These chart signals alert you to the possibility of a trendchange. You must analyze them in light of the entire situation for thecommodity you are studying. Do not use them as your sole decision-making guide.THE VERY RELIABLE HEAD-AND-SHOULDERSFORMATION
For several reasons, many technical analysts get excited when theysee a head-and-shoulders chart formation developing. First, it is
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probably the best known chart formation. And since technicalanalysis can be a self-fulfilling discipline, the more traders who recognize it, the more likely its promise will be fulfilled. Even dyedin-the-wool fundamental traders cringe at the thought of tradingagainst a head-and-shoulders formation. They’ll stand aside first.Head-and-shoulders formations are among the best knownbecause they stand out on the charts. Everyone sees them and triesto trade them. For these reasons, they have come to be known as oneof the most reliable of formations. Novice technicians, as well as experts, are eager to take advantage of them. Not only are head-andshoulder formations reliable as reversal indicators, but they alsoproject a price objective.A head-and-shoulders formation is a harbinger of a major reversal in the trend of the commodity or index being charted. Thisformation can be either a head and shoulders or an inverted (reverse) head and shoulders.The head-and-shoulders formation signals the end of an uptrend. The inverted head-and-shoulders formation alerts traders tothe end of a downtrend (see Figure 6.13).The head-and-shoulders formation simply portrays three successive rallies and reactions. The second or middle rally reaches apoint higher than the other two rallies. The formation looks like thesilhouette of a person. The left shoulder is the first rally, the head isthe second (middle), and the right shoulder is the third.
Volume Is the KeyAs previously mentioned, the volume of trading must be watchedclosely. It is the key that tells you what the market is really thinking.During the first rally and reaction represented by the left shoulder of the formation, volume expands materially on the rally andcontracts noticeably on the reaction. The overall volume is considered heavy during the development of this shoulder.During the second rally and reaction, which forms the head,volume is high on the rally phase. But the overall volume may belower than the overall volume that occurred during the formationof the first shoulder.When the right shoulder forms, the overall volume drops evenlower. This third rally fails to reach the high established by the second (the head) rally and is a distinct sign of weakness.
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6.13
Inverted Head and Shoulders
The head-and-shoulders formations are considered by many chartists as one ofthe most reliable. Besides heralding a trend change, they often indicate the sizeof the next move.
Chart courtesy of “Pocket Charts.”
As soon as the third rally fails, the technician draws a line connecting the lows created by the failure, or reaction, that occurredwhen the right shoulder and head were formed. A line drawn usingthese lows forms the neckline of the formation. It should be notedthat no head-and-shoulders formation is considered complete or reliable until subsequent price action breaks the neckline.Another unusual phenomenon often occurs at this point. It iscalled the pullback or return move. Once the neckline is broken,prices drop below the neckline (or above it in the case of an inverted head and shoulders) and then are drawn back up to the trend line(or down to it in the case of an inverted formation).This characteristic of trend lines was discussed earlier. A broken uptrend line, after it has been penetrated by the bear move, of-
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ten becomes a resistance area for future bull moves. Prices seem tobe attracted to and cling to straight lines.Technical traders, who are convinced a valid head-and-shoulders formation has been formed, use the pullback move as theirsignal to enter the market or add onto their position. If volumeincreases after prices bounce off the neckline, it confirms the factthat a major trend reversal has occurred.
How Do You Calculate Objectives?The first price objective of a head-and-shoulders formation is calculated by measuring the distance between the neckline and thehigh (or low) made by the top (or bottom) of the head. Multiple objectives can be calculated by doubling or tripling this measurement.Once the move begins, you must double-check and confirm theaction by referring to other price-trend indicators. For example, inorder for a trend reversal to continue to make a substantial move,other technical formations are likely to come into play and be fulfilled. Confirmation chart formations are also useful.Volume and open interest provide additional clues. Once thetrend reversal starts, volume should increase and open interest mustbe building in the direction the market is now trending. You alsolook to see what the large traders with reportable positions and thecommercial hedgers are doing. This information should be availablefrom your broker and is reported by the Commodity Futures Trading Commission.You should highlight on your charts the areas where the moveis most likely to encounter resistance. Then study the price action asthese points are reached. Does the volume increase and does theprice bust right through the resistance? Or do the price movementand volume slow down? This tells you if you should stay in themarket and look for a second, third, or fourth objective, or take yourprofits and look for a new trading opportunity.Head-and-shoulders formations can more closely resemble aPicasso than a Renoir. It’s common for them to have two or threeshoulders or even multiple heads. Sometimes the formations are angular, reminiscent of Picasso’s cubist period. Seldom are they simple and perfectly formed.Therefore, head-and-shoulders formations can be misleading,
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especially when the right shoulder is formed. If it doesn’t break theneckline, prices can continue sideways for a long time or even movein the unanticipated direction. Even when the neckline is brokenand the formation is complete, the formation may still be highly reliable, but it could be a very expensive lesson if you bet the farm onthe first objective always being reached.CONTINUATION CHART FORMATIONS
As discussed earlier, the most common chart formation that indicates that a price trend will continue is the trend line. But what happens when a trend line is broken? Should you immediately reverseyour position, close it out, and stand aside, or should you wait outthe reversal until the market decides where it is headed?Much of the decision depends on how the trend line is brokenand the changes that take place in volume and open interest at thattime. Also, you must consider how close the price is to major support and resistance levels.Always remember that even the strongest trends do not roll onindefinitely without an interruption. It sometimes helps to think ofthem as long distance runners, who must occasionally back off toget their wind.There is a very interesting financial reason for this. It’s calledprofit taking. Following a sharp up or down move, some of thetraders on the correct side of the move will want to cash in their position and pocket their profit.There are other reasons as well. The move may enter a supportor resistance level, causing traders to evaluate their positions. Orsome fundamental news or a well-circulated rumor can cause atrend to stall or temporarily congest.At these junctures, traders become uncertain and are not surewhether they are looking at a trend reversal or just a place where themove is pausing to catch its breath.TRIANGLE OR COIL FORMATIONS
The triangle or coil formation develops when a trend hits a pricelevel where the buying dries up (see Figure 6.14). The move stalls.Profit taking develops. The “bulls” second-guess themselves. The
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F I G U R E
6.14
Coil Formation
The coil formation indicates prices are going to make a major move.Unfortunately, it is not always clear whether the breakout will be up or down.
Chart courtesy of “Pocket Charts.”
market moves sideways. Each successive high is lower, and eachsuccessive low is higher. A triangle is formed where the uptrend lineand the downtrend line meet.Prices move into the apex of the triangle, which forces them tomake a move up or down. About 60 percent of the time prices continue in the direction they were going when they entered the triangle, thus continuing the trend.Sophisticated technical analysts categorize triangles into fourgroups: symmetrical, ascending, descending, and inverted triangles. This approach increases the reliability of the signals. The symmetrical triangle is the one just described above.With the ascending triangle, the top line is horizontal, while thebottom line slants to meet the top line. This formation suggests thata supply of the commodity is available at the price level of the top
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line, but there are no sellers below it. Prices are drawn up and finallybreak out to the upside. The descending triangle is just the oppositeand is a harbinger of lower prices. The horizontal line, like the baseof a right triangle, is on the bottom. The hypotenuse descends tomeet the base, and prices break out to the downside. The invertedtriangle looks somewhat like a funnel and represents a very nervousmarket. Prices can go either way out of this formation.BOXES, FLAGS, PENNANTS, DIAMONDS
These chart formations are more reliable than the triangles. Theirgraphic names help you to spot them easily.The box formation takes weeks or months to develop. Pricesmove sideways, with the highs and lows staying at the same levels,or in a channel. A vertical line drawn at both ends of the tradingchannel forms the box.The box occurs when there is a tug-of