Technical Reuters

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TechnicalAnalysis

OPEN LEARNING

Workbook

An introduction

U S grossn a tion al

debt $4 trillion

1992

Klondyke

go ld rush

1896

Ford in troduces

the Model T

1908

Prohibitio n

repealed

1933

The G reat Crash

1929

Bretto n Woods

Conference

1944

Sput nik laun ched

1957

First silicon

chip1958

First man on

the moon

1969

U S drops

gold sta ndard

1971

OPEC raises

oil prices

1979

Stock market crash

1987

AcenturyoftheDo

wJonesIndustria

lAverage,1896-

1996

6000

5000

4000

3000

2000

1000

0

19901980

19701960

19501940

19301920

191019001896

First I BM PC

1981


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3/154

TechnicalAnalysis

OPEN LEARNING

An introduction

Workbook

Designed, co -autho red a nd Desk Top Published by

Keith A. Rogers, Traini ng and Learni ng Design( 01280) 848562

Co-autho r, Glyn Bra dn ey, Reuters UKI Product Management Graphics and Techni cal Analysis

Project sponsored by Amanda Rogers, Reuters European

The designer and authors wish to thank the following subject

matter experts for their valuable contributions to t his workbook:

Linzie Barra tt, Reuters National

Pinder Grewal, Reuters UKI TrainingJohn Le H unte, Reuters I nternational

Ann ette Jam es, Reuters UKI Traini ng

Heather Jarrett, Reuters European

Richard Lyons, Reuters European

Sanjay Tan na , Reuters National

And rea Tinker, Reuters International

Howard Friend, Seni or Techni cal Analyst, MCM, London

Thanks are also due to Dow-Jones Telerate, Wall Street Journal Europe

for supplying an d g iving permission to use the photog raph of

Cha rles Dow

Version 1.0

Decemb er 1996

Reuters Ltd 1996


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ContentsTechni cal Analysis

1

Contents

Technical

Analysis

Before you start

Page3

IntroductionSection 1

Page5

Chart typesSection 2

Page25

Time

Place Pace

PatternsSection 3

Page55

IndicatorsSection 4

Page91

Waves, numbers andcycles

Section 5

Page113

ooxoxooxooxooxooxo

A day in the life of a

technical analyst

Section 6

Page135

1, 1, 2, 3, 5, 8, 13, ?


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Contents Techni cal Analysis

2

Section 1 Introduction

IntroductionProducing a chartThe development of technical analysisSummaryQuick quiz questionsOverviewFurther resourcesQuick quiz answers

Page

712162121222324

Section 3 Patterns

IntroductionTrendlines

Continuation/consolidation pattternsReversal patternsSupport and resistance linesMoving averagesRelative performanceGapsCharting exercisesSummaryQuick quiz questions

OverviewFurther resourcesQuick quiz answers

Page5760

626672768082858787

888990

Section 2 Chart typesIntroductionLine chartsBar chartsCandlestick chartsVolume chartsOpen interest chartsPoint and figure chartsCharting exercises

SummaryQuick quiz questionsOverviewFurther resourcesQuick quiz answers

Page2728343638404249

5151525354

Section 4 Indicators

IntroductionRelative Strength IndexStochastic oscillatorsMoving Average Convergence DivergenceCharting exercisesSummaryQuick quiz questionsOverviewFurther resourcesQuick quiz answers

Page

939698

102106109109110111112

Section 6 A day in the life of a technical analyst

IntroductionIts what people say...An early start...

SummaryWhats next?

Page137139144

148148

Section 5 Waves, numbers and cycles

IntroductionElliott Wave Theory and Fibonacci numbersGann chartsCharting exerciseSummaryQuick quiz questionsOverviewFurther resourcesQuick quiz answers

Page115120124128129

129131132133


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Before you startTechni cal Analysis

3

Time

Place PaceWhat does this workbook contain?What is this package and who is it for?

Time

Place Pace

Before you startThis section !

IntroductionThis summa rises the development o f techn ical

an alysis an d th e Dow Theo ry.

Chart typesThis section dea ls with th e main ways in which pricesand financial data can be plotted on a chart togetherwith the uses for each chart type.

PatternsShould I buy or sell? Cha rting techn iques often give

rise to pa tterns which can b e used to help you

decide.

IndicatorsCan you pred ict future ma rket trend s? This section

describes the various types of ind icato rs availab le.

Waves, numbers and cyclesMarkets follow cycles and patterns of buying and

selling mo ve in waves... or d o th ey? Perh aps the

markets are governed b y mathemat ical laws or are

they ruled by chao s?

A day in the life of a technical analystThis is what it is really like!

This workbook contains the following sections each of which areindicated by the following icons:

In order to provide an effective quality service youneed to understand the ma rkets in which your

customers operate. This workbook is an open learning

package designed to give you a ba sic understanding of

techn ical an alysis. The workbo ok ha s also been

designed to cater for the need s of a num ber of different groups.

Techn ical an alysis has become on e of th e key techn iqu es available to

Reuters customer s with th e introd uction of th e 3000 series ofproducts and the a ccess they provide to historical price data .

Wheth er you are in sales, custom er support, o r client tra ining, if you

are in volved in selling or supporting 3000 prod ucts, this workboo k is

for you.

It will take you through techn ical an alysis from first principles, from

creating your first chart with pencil and paper, to using sophisticated

ana lysis tools and techniques. By the time you h ave completed t his

workbook you will be able to use most of the main markettechniq ues and understand when they should b e applied.

You m ay find it useful to ha ve access to the 3000 produ cts and

Reuters G raph ics to d o th e exercises in t he workbook. Go ing

through the exercises will help you to become fa miliar with the

software, as well as learning the analysis techniques.

You m ay also fin d the workbook useful as Technica l Ana lysis is one

of th e subjects which for ms part of th e examina tion syllabus leadingto eith er Fellowship o r Associateship o f th e ACI I nstitute.

ooxoxooxooxooxooxo

1, 1, 2, 3, 5, 8, 13, ?


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5

7

12

16

21

21

22

23

24

This section of t he mo dule should ta ke no mo re

tha n 60 minutes of study time. You ma y not ta ke

as long as this or it may take a little longer

remember your learn ing is ind ividual to you.

12

3

6

9

12

4

578

1110

Contents

Introduction

Producing a chart

The development of technical analysis

Summary

Quick quiz questions

Overview

Further resources

Quick quiz answers


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Section 1Introduction

6

He was an experienced newspaper reporter, with an early trainingunder Samuel Bowles, the great editor of the SpringfieldRepublican. Dow was a New Englander, intelligent, self-repressed,ultra-conservative, and he knew his business... Knowing and likingDow, with whom I worked in the last years of his life, I was often,with many of his friends, exasperated by his conservatism... In thelanguage of the prize ring, he pulled his punches.

How Good is the Dow Theory? Part 1 by Bil l Dunbar

Technical Analysis of Stocks and Commoditi es , Vol. 3:2 (59-63), 1985


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7

Introduction

From the early days of shares being bough t an d sold and trad ing in

commod ities such a s rice, trad ers and investors have noted trends

and patterns in prices over time. Modern markets abo und in sayings

such as:

Most investors, individual and institutional, traders, brokers, dealers

etc are seeking the best return on their investments or best profit on

their dea ls. It is therefore obvious that any metho ds these market

players can use to reduce the risk of losing their money and improve

their ch an ces of rewards will be welcomed. B ut is it possible to

forecast when it is a good time to buy or sell shares, trade futures

contra cts etc?

Cha rts and ana lytical techniques are used to forecast prices and

influence trading strategies in a ll finan cial markets. Some of the

more familiar chart uses involve the following:

Whole stock markets

Stock market sectors

Ind ividual shares

Currencies

Interest rates

Commodities agriculturals, metals, energy and softs

Futures

There a re two ba sic types of ma rket ana lysis available to guide

market players, each ha ving its own experts:

Fundamental analysis

Technical analysis or charting

In practice investors and trad ers will proba bly practice an d/or use

tools and techniq ues from both types of ana lysis.

The trend is your friend

Go with the trend

But what do th ese mean? Cha rts such as the one shown below of the

Dow Jones Industrial Index over the last ten years can be seen in

financial publications such a s the Financial Timesand The Wall Street

Journal an d o n electro nic da ta systems such a s the RT.

You may h ave asked yourself qu estions such as:

Where d id th ese sayings origina te?

Are th ese sayings true and what use are they?

Who uses these charts?

What do these charts indicate?


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11

Theory C Supply and demand fundamentals

Spreads Months, Exchanges, Cash/futures

Flow of funds Volume and open interest

Seasonals Weath er, econo my

Reports Expectat ions versus reality

Favoured by floor traders

Whichever type of ma rket player you are in terested in will influence

the way you u se this workbook. H owever, all th e fact ors involved in

the ab ove theories have either been m entioned a lready or arediscussed later.

H aving h ad a look at th e various theories in the

previous section, b efore mo ving o n, it ma y be useful tonote h ere if there are any charting techn iques and

their application to a market sector tha t particularly

interest you. For exa mple, if you a re interested in

buying and selling shares which techniques would you

like to know more a bout?

Theory B Classical charting

Trends following Moving averages etc

Chart formations Trian gles, Hea d & Shou lders etc

Trend lines Channels

Cycles

Favoured by public advisors


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12

Producing a chart

This workboo k has been d esigned to give you th e basic knowledge

and understand ing of the principles and techniq ues used in

charting and the Reuters products associated with cha rting. This

knowledge a nd understand ing will help you identify, meet a nd

support the needs of your customers.

Ho wever, before moving on to learn about the more d etailed aspects

of charting try the following activity ...

Producing a chart: Exercise 1The d ata oppo site shows the closing prices for Reuters

shares over a 50 da y period in ea rly 1996.

All you need to do on th e graph pa per on th e opposite page is

mark the closing price on the vertical axis for each day. Use a

pencil to mark each price with a cross or dot any mistakes

can easily be erased. Then join your marks to pro duce yourchart you ma y find using a colour helps.

Although many computer graphing or charting programmes

will produce the sam e results, by carr ying o ut th is exercise you

will see how straightfor ward ch arting can be a t a basic level.

You will prod uce the simplest form of ch art wh ich con nects

consecutive closing p rices for a n instrumen t it is called a

line chart .

On ce you have drawn your char t ha ve a close look and see if

you can see any patterns. If there are, then indicate them o n

your char t.

The chart of what you should see is shown on page 14.

Day PriceDay Price

1 5.667 62 797

2 077 72 487

3 967 82 987

4 857 92 987

5 157 03 977

6 947 13 877

7 5.357 23 077

8 777 33 567

9 497 43 567

01 287 53 657

11 467 63 5.057

21 177 73 747

31 377 83 557

41 377 93 5.157

51 167 04 657

61 257 14 647

71 857 24 647

81 057 34 657

91 347 44 267

02 547 54 777

12 747 64 187

22 467 74 777

32 987 84 767

42 087 94 767

52 297 05 5.067


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13

Price

ofshares

Days

800

790

780

770

760

750

740

10 20 30 40 50


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14

800

790

780

770

760

750

740

10 20 30 40 50

Priceofshares

Days


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15

Producing a chart: Exercise 1You should h ave produced a chart similar to that

shown on the previous page.

Ha ving dra wn the chart, which should n ot ha ve been

all that difficult, you may have seen the pa tterns

indicated here:

A pattern showing a do wnward trend in th e

prices from d ay 10 to 19

The pa ttern between day 22 an d 30 resembles a

head and shoulders of a person

Looking at this chart if an investor ha d bo ught

shares about d ay 21 at 747 and sold them a bout d ay

31 at 770 then his or her profit, excluding any

brokerage, would have been 23p per share.

R

You h ave now prod uced your first chart ! The exercise should n ot

have been that d emand ing and from your results you can probab ly

appreciate the pra ctical use chart ing can be put to in a very simple

way. H owever, market players will be basing th eir trading strategies

on a little more than a line cha rt over 50 days for an y particularshare!

800

790

780

770

760

750

740

10 20 30 40 50


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17

US gross national

deb t $4 trillion1992

Klondyke

gold rush

1896

Ford introd ucesthe Model T

1908

Prohibition

repealed

1933

The G reat Crash

1929

Bretton Wood s

Conference

1944

Sputnik launch ed

1957

First silicon

chip1958

First ma n on

the moon

1969

US dro ps

gold standa rd

1971

OP EC r aises

oil prices

1979

Stock market

crash

1987

A century of the Dow Jones Industrial Average, 1896 - 1996 6000

5000

4000

3000

2000

1000

0

19901980197019601950194019301920191019001896

First IBM PC

1981


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18

As ha s already been men tion ed Do w was a memb er of th e New York

Stock Exchan ge an d in his continuing studies of the mar kets he

formulated what is now known a s Dow Theory.

Dow never wrote a b ook about his theories but h e published them a s

a series of The Wall Street Journaleditorials aroun d the turn o f the

centur y. These editorials were collected together and reprinted in

1903, a shor t time af ter Do ws dea th in Decemb er 1902.

Dow ha d n oted th at a simple line plot of index price against time

gave rise to zig-zag pat tern s which ha d certa in characteristics

depending on market trends. It is these basic patt ern s whichcha rtists still use tod ay, albeit with m an y refinements.

Dow formulated six basic principles from his study of the markets

which a re summar ised a s follows:

1. Average pricesdiscount everything

2. The market moves intrends

Dow used closing pricesexclusively tocalculate h is averages. He a lso

assumed that the prices discountedever ything still an un der lying

assumptio n of Techn ical ana lysis.

Uptr ends have a patter n of rising

peaks and troughs the opposite for

downtrends.

Dow identified three distinct types of

trend:

Primaryor major. These lasted ayear or more and could be

considered to b e like a tide. Secondaryor intermediate. These

were like wavesan d lasted 3 weeksto 3 month s.

Minor. These were likeripplesandlasted fo r less tha n 3 weeks.

Uptrend

Downtrend

Primar y trend

Intermediatetrend

Minortrend


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3. Major trends havethree phases

Phase 1This is an accumulationpha se which

moves sideways and where astuteinvestors are buying on an informed

an alytical basis.

Phase 2This is an uptrendperiod where moreinvestors begin to participate based

on an alysis an d b usiness news.

Although the trend is up, the ma rket

prices zig-zag during correctionsorpullbacks.

Phase 3After a m arket price peakthere isanother accumulation period during

which th ere is increased investor

activity as the ma rket news becom es

more widely available.

The en d o f Ph ase 3 is marked by a

downtrend and a return to a period

of accumulation.

Ralph Nelson Ell iott

developed the Dow

Theory further in the

1920s to provide an

overal l perspective of

market movement

expounded as ElliottWave Theory this isdescribed later in

Section 5.

4. Averages mustconfirm each other

Dow was convinced th at bot h the

Ind ustrial and the Railroad indices

had to be moving in the samedirection to confirm a market trend.

Accumulation Uptrend Pullbacks

Peak Accumulation Downtrend

These char ts show modern Dow Jones average indi cies the upper

charts show confirmati on whereas in the lower charts the markets are

moving apart.

Chart of DJIA

Chart of DJTA

Char t movements in broadagreement conf irming the markettrend

Chart of DJIA

Chart of DJ 20Bonds

Chart movementsshowing divergence


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5. Volume must confirmthe trend

6. A trend is assumed tobe in effect until itgives definite signals

that it has reversed

Volume represents the tota l trad ing

activity for a finan cial instrument in a

particular time period. Dowconsidered th at volume was important

additional information in confirming

mar ket signa ls. The volume should

expand in th e direction of th e major

trend.

This is the basis of tren d an alysis but it

is no t always easy to identify a tren d

reversal. For exam ple, is a ch an ge just

a correction or the start of a down-trend?

Modern ch artists have a numb er of

tools and techniques available to h elp

which are d escribed later:

Support and resistance levels

Tren d lin es

Mo vin g averag es

Criticisms of the Dow TheoryDo ws theo ries were never intend ed to indica te specific stocks which

should be bough t or sold but were intend ed to id entify the stockmarkets major trend based on closing price information . Because

this type of cha rting is based o n trend-following it cannot predictexact beginnings and reversals of trends. Nor can th e char ting

predict the exact d uration a nd extent of trend s. H owever, despite

these limitation s the Dow Theo ry has been used to give 40 corr ect

signa ls in the period 1897 1991. Du ring this period on ly 5

incorrect signals were forecast.

Dow intended his indices to be market barometers which mean t tha t

the selection of ind ividua l stocks to buy or sell was entirely in the

ha nd s of investors. Origina lly it was not p ossible to buy or sell a stock

index. H owever, since th e early 1980s tradin g in stock index futures

contra cts has been possible the Chicago Mercantile Exchange

laun ched Stan da rd & Po or 500 Stock Index futures in 1982 and

LIFFE offered FT-SE 100 Stock Ind ex futu res an d o ptio ns in 1984.

Although the Dow Theory has its limitations, it has provided thebasis of ma ny of the ch arting techniques which are described later

in th is workbook.

Conf irmation when:Increasing volume onuptrend hi ghs anddecreasing volume onupt rend lows opposite for downtrend

Volume

data


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Summary

You h ave now finished the first section o f the workboo k and youshould h ave a clear understand ing of:

The differences between technical an d fund amenta l

analysis

The un der lying prin ciples an d uses of tech nical a na lysis

The prod uction of a b asic chart

The d evelopment of technical an alysis and the D ow

Theory

As a check on your understand ing of this section you should tr y the

Quick quiz question s. You m ay also find the section Overview a

useful revision aid.


1. Which of the following statements are true concerning theunderlying principles of technical analysis?

a) The main focus is on what ought to

happen in th e market

b) Patterns exist in market behaviour

c) History repeats itself

d) Market action discounts nothing

True False

2. According to D ow Theor y, briefly describe what is happening

in the various phases of a major trend numb ered 1 to 6 in this

diagram.

You can check your answers on page 24.


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Further resources

Books

Technical Analysis of the Futures MarketsJoh n J. Murph y, New York Institute of Finance, 1986

ISBN 0 13 898008 X

Technical Analysis ExplainedMartin Prin g, McG raw-H ill, 1991

ISBN 0 0705 1042 3

The New Commodity Trading Systems and MethodsPerr y Kaufman , J. Wiley & Son s, 1987

ISBN 0 4718 7879 0

Technical Analysis from A XSteven Achelis, Prob us Pub lishing Co., 1995

ISBN 1 55738 816 4

Timing the Market How to profit in Bull and Bear Markets withTechnical AnalysisCurt is M. Arn old, P robu s Publishing Co., Revised Ed ition 1993

ISBN 1 55738 496 7

Charters on Charting How to improve your stockmarket decisionmakingDa vid C ha rters, Rushmere Wynne, 1995

ISBN 0 948035 21 8

Technical Analysis of Stocks and Commodities

Taking Stock of Commodity Trading Methodsby B . VenitisVol. 1:6 (129-132), 1982/3

A map for the trading jungleby G.D. NobleVol. 4:2 (81-82), 1986

Real world technical analysisby K. Calho unVol. 9:3 (103-103), 1991

Dow Theoryby M.F. Bowm an an d T. Ha rtleVol. 8:9 (359-363), 1990

Financial TimesA series of a rticles by G illian O Con no r in Weekend Mon ey

Picking the pops from the charts 19.8.95How the trend can become your friend 2.9.95How candlesticks can shed light on trends 9.9.95Indicators confirm your first thoughts 16.9.95Waves that boom and crash 30.9.95Simple approaches to a complex jigsaw 14.10.95In search of the stars 21.10.95

Investors Chronicle

A series of ar ticles by Robin G rff iths

Making a science of an art form 8.9.95The pencil is mightier than the PC 15.9.95What are the charts telling us now 22.9.95


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Quick quiz answers Your notes

1. Which of the following statements are true concern ing the underlyingprinciples of technical analysis?

a) The main focus is on what ought to

happen in the market

b) Patterns exist in market behaviour

c) H istor y repeats itself

d) Market action discounts nothing

True False

2. According to Dow Theory, briefly describe what is happeni ng in the

var ious phases of a major trend numbered 1 to 6 in thi s diagram.

Phase 1: Accumulationwhere pr ice action is moving sideways

Phase 2: Uptrendwhere investors begin to participate

Phase 2: Correctionsor pullbacks to m arket prices

Market peak

Phase 3: Accumulationperiod after peak

Ph ase 3: End m arked by a downtrend


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ooxoxooxooxooxooxo

Contents

27

28

34

36

38

44

46

49

51

51

52

53

54

12

3

6

9

12

4

578

1110

This section of the module should take about 90

minutes to 2 hours of study time. You m ay no t

take as long as this or it may take a little longer

remember your learn ing is ind ividual to you.

Introduction

Line charts

Bar charts

Candlestick charts

Point and figure chartsVolume charts

Open interest charts

Charting exercises

SummaryQuick quiz questions

Overview

Further resources

Quick quiz answers


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Section 2Chart typesooxoxooxooxooxooxo

26

The Will Rogers theory has only two rules.Rule 1: If it dont go up, dont buy it.Rule 2: If it dont go down, dont sell it.

The Will Rogers Theory of Point and Figure Trading by J. Adam Hewison



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ooxoxooxooxooxooxo

Introduction

The ch art ist ha s a wide variety of techn ical an alysis too ls an dtechniq ues to choose from. All of them req uire some type of char t

plotting. Chart s can b e plotted by hand as you ha ve already carried

out, or more likely toda y charts are produced with com puter

applications such as Reuters Graphics and Reuters 3000 products.

Althou gh this wide ch oice exists most chart ists tend to have

favoured chart types and ana lytical method s which th ey prefer using.

This section covers the basic types of ch art s availab le, how th ey are

created an d, to some extent, how they are used. Cha rt types range

from simple line plots and b ar cha rts, point a nd figure charts to

complex candlestick plots which originated in Japan . Line cha rts are

the simplest form of chart connecting consecutive closing prices and

show th eresultof ma rket m ovements. Cand lesticks chart Open/High/Low/Close prices and provideedited highlightsof what ishappening.

The ch art types covered include:

Line

Bar

Candlestick

Point and figure

Volume

Open interest

For some of these chart types there are activities for you to carry out

to illustrate particular p oints you will benefit if you ta ke the time

to perfo rm th e activities but if you do no t ha ve time then thean swers are a lways illustrated . You m ay find it useful to use a pen cil

for these act ivities its a lot easier to erase an y mistakes! You m ay

also find it useful to photo copy the original blank charts as a backup.

Each chart type is discussed using the fo llowing p rocess:

??

What is it?

How is it used?

Important information

Useful diagrams

Examples

Ch t t


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The line chartis the simplest form of chart joining a series of pointsfor instrument data on the vertical axis (Y-axis) and a timescale on

the h orizon tal axis (X-axis).??

Line ch art s are not freq uent ly used tod ay. Typically Bid , Ask, H igh,

Low or C lose prices are used fo r th e vertical axis an d timescales used

can var y from tick (ever y price plotted co nsecutively) to ho urly, da ily

and weekly.

There are a number o f ways in which line chart d ata ca n be plotted two involve the vertical axis and on e the timescale.

Arithmetic vertical scaleThe mo st commo n m ethod is to use an a rithmetic scale where each

division represents the same price difference.

Logarithmic vertical scaleThis method uses a price scale where the Y-axis is constructed using

a loga rithm ic scale. The ch art still uses an ar ithmet ic timescale so

the char t is often termed semi-logarithmic. The main purpose forusing a log arith mic scale is to keep price mo vements involving very

large rises and falls in perspective. In the Equity market many

players believe th at it is better to ch ar t stocks which h ave seen very

large rises/falls in prices using a logarithm ic Y-axis rath er th an use

an arithmetic scale.

TimescaleDepend ing on the timescale used fo r each arithmetic division on

the ho rizonta l scale, the appearan ce of a line char t can vary

dra matically. For example, the appeara nce of a ch art using 1

division p er week for a closing pr ice line chart will look very

compressed compared with one using one division per day. Chartists

select the m ost appropriate timescale divisions depending on the

type of ana lysis and trad ing need s they have.

Arithmetic chart Semi-Log chart

In both cases a movement f rom 2 4 and 4 8 i s100% . I n the ari thmetic chart the movement lookstwi ce as big as it really is. I n the semi-logari thmi cchart the movements look the same. Why not

measure the line lengths to check?

Dai ly prices

Weekly pr ices

The same prices have been plotted using dai ly and weekly

timescales. You can see how much more compressed thedai ly char t looks.

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109876

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Line charts

Arithmetic charts


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S ti 2Chart types


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Arithmetic chart Semi-logarithmic chart

1 00.01

2 36.01

3 05.01

4 44.01

5 52.01

6 52.01

7 05.01

8 00.01

9 83.01

01 00.01

11 83.01

21 00.11

31 52.31

41 57.31

51 05.41

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02 05.41

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32 88.31

42 05.41

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72 36.41

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03 36.41

13 13.51

23 05.61

33 00.81

43 00.22

53 52.32

63 00.02

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93 52.02

04 00.12

Day Price

Iomega Corp d aily

closing prices



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ooxoxooxooxooxooxo3800

3790

3780

3770

3760

3750

3740

3730

3720

3710

3700

3800

3790

3780

3770

3760

3750

3740

3730

3720

3710

3700

Daily chart Weekly chart

Day Price

FT-SE 100 Index daily

closing prices

1 6773

2 2573

3 3273

4 7073

5 8273

6 4573

7 9573

8 6773

9 4573

01 0973

11 8773

21 9873

31 4673

41 7473

51 2573

61 0673

71 5773

81 7473

91 8473

02 9373

2 2573

6 4573

01 0973

51 2573

91 8473

Week

(= day

above)

Price

FT-SE 100 Index weekly

closing prices

Section 2Chart types


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32

10

11

15

12

13

14

16

20

17

18

19

21

22

23

24

10

11

15

12

13

14

16

20

17

18

19

21

25

22

23

24Exercise 2aYour charts

should have

looked

something

like these.

R

Arithmetic chart Semi-logarithmic chart


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Chart typesooxoxooxooxooxooxo

34

The bar chartis the most common way of indicating price data usedby Western cha rtists. A bar cha rt plot s instrum ent d ata activity as a

series of verticalbars each of which covers a specific period.??

In m ost cases the period bar indicates High, Lowand Closepricesfor historical data and High, Lowand Lastfor real-time pr ices. Som ebars indicate Open/ High/ Low/ Closeprices especially forexchange tra ded instruments but Open pr ices are not always

available for historical da ta. Just as for line charts, bar charts can use

an arithmetic or a logarithmic scale for th e vertical axis anarithmetic scale is most commonly used.

Drawing a barBars are dra wn as follows:

1. D ra w a verticalline between th e Highand Lowprices.

2. Add a short bar to the rightof th e vertical bar as the CloseorLastprice. The close price is, as its nam e implies, the price at theclose of th e market. When t he ma rket next opens and the

financial instrument is traded o nce aga in the close price

becomes the last price.

3. Add a short bar to the leftof th e vertical bar representing theOpenprice.

Bar charts are useful as they provide highlights ofwhat is happening in the market but as you will see,

in compa ct cha rts it is not always easy to read the

bars!

High

Low

Close or Last

During a strong uptrend the closingprice will usually be n ear the p rice

High.

If you see this pattern d uring a strong

uptren d it is usually taken a s a

warning signal.

High

Low

Close or L ast

During a strong downtrend th eclosing price will usually be n ear the

price Low.

If you see this pattern d uring a strong

do wntren d it is usually taken as a

warning signal.

Prices on RG/RTA are displayed according to the

following order. For example:

750 760 740 745Open High Low Close

Market closed

at 745

Bar charts

High

Low

Close or L ast

Open

High

Low

High

Low

Close or L astThe Last pri ce moves up anddown the bar as its pri ce

changes. At the end of theperi od the final Last pri cebecomes the Close price.

When u sed in char ti ng fu tu res the Open baris often drawn shorter i n l ength than thatused for the Close.



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Chart types

35

ooxoxooxooxooxooxo

Bar charts

A dai ly bar chart for LME Copper3 month forward cont ract pri ces

This shows a magni fi edview of the area in thechar t you can see the

bars more clearly

A dai ly bar chart for the Standard &Poor 500 Index pri cesThis shows a magni fi ed

view of the area in thechar t you can see thebars more clearly



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ypooxoxooxooxooxooxo

36

A candlestick chartplots instrumen t da ta a ctivity as a series of twodimensional candlesand their wicks, each of which covers a specificperiod. The candle bodyindicates the Open/ Closeor Lastpricesand thewick is used to indicate th e High/ Lowprices similar to thevertical bar used in ba r cha rts.

In addition a candlestick provides a visual indication of the relative

price movement of th e instrument for the period.

If th e Close or Last is lower than th e Open price then thecand le body is coloured black

If the Close or Last is higher tha n the O pen price then the

cand le body is coloured whiteor redas used originally

??

Although candlestick charts are a relatively recent introduction into

western technical analysis, Japanese rice traders used these charts

centuries ago. Many exponents of candlestick charts believe that

pattern s produced even by 2 3 days trading can give importan tsigna ls for shor t-term trad ing ma rkets such as futures.

Drawing a candlestickCand lesticks are d rawn as follows:

1. D ra w a verticalline between th e Highand Lowprices which isknown as the wickor shadow.

2. Overlay on this wick a candleor bodyfor which its top an dbot tom limits are given b y its Openand Close/ Lastprices. If theClose is lowerthan th e Open price, then colour the cand le black.If th e Close is higherthan th e Open, then leave the cand lehollowor white.

Candlestick charts use what may seem a bewilderingnumber of na mes for cand les and their patterns.

Below are just a few explanation s of cand les and

patterns:

This shows thatmarket playersare buying

This shows thatmarket playersare sell ing

Candlestick charts

Spinn ing top

High

Low

Close

Open

High

Low

Open

Close

Upper shadow

Lower shadow

Doji Open/Close are the same

Bearish

engulfingBullishengulfing

Engulfing patterns

Star formation Bearish Evening Star Morning Star

Black orwhi te body

Gap betweenbodies


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38

Point and figurecharting is a simple techniq ue for plotting stockand commod ity prices which only charts significant cha nges in

order to iden tify trends. The ch arts are simple and easy to con struct,

involve no timescale and on ly involve price changes of a u ser

determined amount.

??

Prior to the introd uction of computerised techn iques this was

proba bly one of th e most popular tech niques due to its simplicity

it is still a too l used in futur es pits. The co nvention is to p lot a cha rt

in vertical column s where the vertical axis con sists of boxesand the

scale is known a s the box size. For example, a user may decide th ateach b ox represents one point in some circumstances and three

points in anot her. Xsand Osare used to chart price movements. Asprices rise an X is placed on th e chart for each price rise equa l to

the cho sen bo x size. An O is used for each price decline equa l to the

chosen box size. A second parameter used is the number of boxes

that constitute areversal. A key featur e of th ese chart s over oth ercha rts is tha t the h orizon tal axis (X-axis) isnottime dependent. For

this reason chan ges in da y are often marked by the da y number orby a colour chan ge.

Choosing the box sizeA small box size an d small bo x reversal n umber will tend to g ive a

large number of X an d O column s. The chart can be mad e coarser

by either raising the box size itself or the number of boxes that

constitute a reversal. It is more common to increase the box size

tha n the b ox reversal number a three box reversalis ver ycommon.

Depend ing upon th e box size and reversal numb er, a point a nd

figure chart could cover a d ays trad ing or tr ading over several

months.

Starting the chartThe cha rt is started by placing a dot in the first box corresponding

to the instrument price. Everytime the price rises (or falls) by the

selected b ox size an X (or O) is placed in th e samecolumn. Xs (orOs) ar e marked in b oxes to the value of th e move.

Xs and Os

0

0000

XX

XXX

Star t dot

Xs marked to thevalu e of thepri ce ri se

A singlebox

Star t dot

Os marked to the

value of the pri cefall

I f the box size is 5 pips and a three boxreversal is chosen, then the ri sing market Xcolumn would have a new column of threeOs introduced alongside it i f the pri ce fellby 15 pips. T he fi rst O would be placedimmediately below the highest X of theprevious column.

Point and figure charts

XXXXX

000

XXXXX

X

X



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39

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ChartingXs (or Os) a re placed in the b oxes until there is a price reversal an d

the p rice falls (o r rises) by the selected bo x size. The ch art no w

moves to the nextcolumn.

If the price falls, thus moving from XO, then the O is placed onebox across and downfrom the last X.

If the price rises, thus moving from O X, then the X is placed one

box across and upfrom the last O.

The horizontal axis is therefore a series of columns showing up and

down price movements. Price movements of less than the point size

selected are filtered o ut.

UsesPoint and figure charts are used to ind icate buy/sell signals and to

identify the following:

XXXXX

00000

XXXXX

000000

Price fal l Move one column to right Move down a box for fir st O Mark as many Os as necessary

for the pri ce fal l

Price rise Move one column to right Move up a box for first X Mark as many Xs as necessary

for the price ri se

Market behaviour

Deman d exceeding supply

Supply exceeding d emand

Supply and demand in balance

XXXXX

0000

0000

0000

0000

0000

0000

XXXXX

XXXXX

XXXXXXX XXX

Point and figure chart

Long up columns Xs

Long d own columns Os

Short up and down columnsmoving sideways

This combinat ionis a buy signal

This combinati onis a sell signal




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40

An exampleThe following is a list of prices which are to be plotted on a point

and figure char t. A char t using a box size of one and a three box

reversal is required .

Prices

15 25 10 15 10 15 5 15 12 15

In a ll cases the price changes are greater tha n 3 so Xs and Os arerequired for every price movement. A chart with a box ran ge 5 to 25

will be sufficient for th e plot.

The cha rt is started by placing a dot in box 15 and then placing X s

in the first column up to 25.

At th is point the price reverses by more th an 3 points it goes down

to 10. Therefore an O is placed in th e next column, on e box d own

and Os continued down to 10.

The pr ice reverses aga in to 15. Now an X is placed in t he n ext

column, one box up an d Xs continued to 15.

You h ave proba bly got th e idea b y now. Why not check the rest of

the chart?

It is worth remembering th at if the price does not rise or fa ll by theselected b ox size, then no entr y is required. A point an d figure char t

only records price movement it is not depend ent on time.

XXXXXXXXXX

5

10

15

20

25

XXXXXXXXXX

00

00

00000

000000

5

10

15

20

25

XXXXX

XXXXX

XXXXX

00

00

00000

000000

5

10

15

20

25

X

XXXX

XXXXX

XXXXX

XXX

XXXXX

XXXXX

XXXXX

00

00

0000

0000000

000

000

0000000

00000

5

10

15

20

25

Star t dot

Xs up to 25

Os in nextcolumndown to 10

Xs in nextcolumn upto 15


Chart typesSection 2o


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41

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A point and fi gure chart of one minute bidprices for spot Deutschemark using a boxsize of 0.0002 and a 3 box reversal

A point and f igure chart of last trade tickpri ces for CBOT US T-Bonds using a boxsize of 0.3125 (1/32) and a 3 box reversal

Section 2Chart typeso


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42

Exercise 3

Plot the Reuters data as a point and figure chart.

Use a box size of 2 an d a three box reversal.

You can check your answer on page 48.

Day PriceDay Price

1 5.667 62 797

2 077 72 487

3 967 82 987

4 857 92 987

5 157 03 977

6 947 13 877

7 5.357 23 077

8 777 33 567

9 497 43 567

01 287 53 657

11 467 63 5.057

21 177 73 747

31 377 83 557

41 377 93 5.157

51 167 04 657

61 257 14 647

71 857 24 647

81 057 34 657

91 347 44 267

02 547 54 777

12 747 64 187

22 467 74 777

32 987 84 767

42 087 94 767

52 297 05 5.067

Chart typesSection 2o


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740

750

760

770

780

790

800

Section 2Chart typesoox


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44

Volumerepresents the total trading activity in a specific period for acommodity or financial instrument. For example, overall volume isthe total numb er of contracts traded during th e day of all contra ct

mon ths of the LIFFE FTSE-100 futures cont ract; also, it is the to tal

number of Reuter ordinar y shar es tha t are bought a nd sold during

the d ay on the Lo ndo n Stock Exchan ge. Usually the volume is

recorded a s a vertical bar at the b ottom of a line or bar chart , so tha t

the price and volume data correspond. The greater th e volume the

higher the vertical ba r.

??

Volume ch art s give a measure of the am oun t of buying and selling

that is taking place in a market. There is a saying in the markets

which ma ny an alysts subscribe to:

Volume confirms price action

The Dow Theory places some emphasis on volume as a method of

con firming market signa ls an d tr end s. Volume is also a u seful

measure of the strength of price movements. High volume acts as a

confirmation of price direction. Low volume tends to be a warning

of lack of market interest at that price level and hence a risk that th e

price direction may chan ge.

When using volume ch art s to confirm price direct ions it is useful to

remember th at ma rket volumes can be lightimmediately beforemarket holidays or before the release of major market statistics.

Drawing a volume chartThe m ost commo n way of d rawing a volume ch art is as a sub-plot on

the same chart as that used to plot the da ta for a line, bar cha rt etc.

for prices. The volume data is usually plotted at the bottom of the

price cha rt using th e same ho rizonta l time axis. The vertical axis (Y-

axis) is usually an arithmetic scale that fits beneath the m ain ch art.

I f prices are in uptrend and volumeshigh, then thi s is taken as confi rmingthe directi on of the trend

If prices are in uptrend but volumes arelow, then thi s may indicate that buyers are

losing interest and a trend change is on theway

Price

Volume

Uptrend

Price

Volume

Uptrend

High

Low

Volume is seldom used by itself but in con junct ion with cha rt

pattern s and indicators which are described later in the

relevan t sections. The fo llowing cha rt summa rises the b asic

market signals that ca n be gauged from price/volume charts:

Price

Volume

Market

Strong

War nin g sign

Weak

War nin g sign

Volume charts

Warning signindicates that the price

trend may change.

Chart typesSection 2oox


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Volume charts

A dai ly price/ volume chart for CBOTT-Bond pr ices

This continuation futures chart showsthe volume data for the front monthcontracts whi ch are joined together

A dai ly last trade price bar chart and a

volume sub-char t for Reuters shares


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Chart typesSection 2ooxoxo


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47

oxooxooxooxooxo


Dai ly pri ce bar chart and open i nterestsub-chart for the COMEX H igh GradeCopper futu res contract September

1996

Dai ly last trade price bar chart andopen interest sub-char t for the CMEIMM Eurodollar futu res contractMarch 1997

Open interest charts areonly appli cable for futurescontracts

Section 2Chart typesooxoxo


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48

XX

XXX

XXXXX X

XXX

X

XX

X

XXX

XX

XXX

XXXXXXXXX

XXXX

XX

XX

X XXX

X

XX

XXXX

XX

X

X

XX

X

X

XX

X

XXXXXXX

X

XXX

X

XX

X

XX

X

XXX

X

XXX

0

0

0000000

0000000 0

0000

0

0

000

0000

0000

000

0000000

00

000

000

0000

000

00

00000

000

00

0000

000

0

00

0

00

00

00

0

00

00

740

750

760

770

780

790

800Exercise 3

Your cha rtshould have

looked

something

like this.

R

Chart typesSection 2ooxoxo


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49

oxooxooxooxooxo

Chart exercise 1

Open Reuters 3000 and in a n ew workspace type in

CBRY.L@BARto d isplay a daily bar ch art fo rCadburyshares. The system will defa ult a 6 mon thhistor y. You sho uld see a screen similar to this.

Now click on t he X-axisbutton in the

bottom toolbar and

change the data to

be viewed to 2 years.

Finally click the Daily,Weekly, MonthyPage tabto d isplay all three charts

for the 2 year period . You

should n ow see a screen

similar to this.

RT

Charting exercises

If you have access to Reuters Graphics and/or

Reuters 3000 you may like to ha ve a loo k at th e

following exercises which have been designed to

help you und erstan d m ore fully the various chart

types described in th is section.

Section 2Chart typesooxoxooxo


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50

Chart exercise 2

Open Reuters G raphics (v3.1) and enter USc1 todisplay a 2 year d aily bar ch art for U S T-bon ds.

The screen shou ld loo k someth ing like this.

Open a new window and using

the Chart menu, open an OpenInterestchart for U Sc1 in thenew windo w. The windows

should look something like those

shown h ere.

Now delete your charts for USc1 and create a bar

chart for CBRY.L. Click on t he PVbutton in

the too lbar to generate a Price/Volumechart.

This char t should look somethin g like this.

RG

Chart typesSection 2ooxoxooxo

S


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oxooxooxooxo

Summary

You h ave now finished the second section of th e workbook and you

should h ave a clear un derstanding of the following cha rts:

Line

Bar

Candlestick

Point and figure

Volume

Open interest

As a check on your understand ing of this section you should tr y the

Quick quiz question s. You m ay also find the section Overview a

useful revision aid.


1. For each of the following diagrams indicate the location of the

High /Low/Open/Close prices.

2. Match the following statements concerning Point an d Figure

charts.

A. Demand exceedingsupply

B. Supply exceedingdemand

C. Supply and demandin balance

1. Long down columns Os

2. Short up and down columnsmoving sideways

3. Long up columns Xs

A & B & C &

3. Which of the following statements are true and which are false

concern ing volume and open interest char ts?

a) Price up and volume up indicate a

weak market

b) Price up and volume down are a

warning sign

c) Price up and open interest up indicate

a strong ma rket

d) Price down and open interest up indicate

a weak market

True False

You can check your answers on page 54.

Section 2Chart typesooxoxooxooxo O


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52

Overview

Line charts

Typically joins a series of , Bid, Ask, High, Low or

Close prices

Vertica l axis Y-axis can be an ArithmeticorLogarithmicscale

H orizon tal a xis X-axis can b e tick, hour, da y,

week, month etc


Plot o f stock or commod ity prices which char ts

significant changes using a vertical axis of boxesand a scale known a s the box size

Price rise indicated by an Xwhen the mo vementequals the box size

Price fallindicated by an Owhen the mo vementequa ls the box

size

Typical cha rts

use a three boxreversal


Line plot of total number of contracts stilloutstandingin a futures market for a specifiedcontract month

Open interest is

calculated by either

looking at the tota l

number of outstanding

long or short positions

not both

Bar charts

Instrument prices plotted as a series of verticalbars

Bar ca n indicate Open/H igh/Low/Close or Last

prices

Volume charts

Vertical bars representing t he total trading activityin a specific period for a comm odity or financial

instrument the greater

the volume the higher

the vertical bar

Measure of the amoun t

of buyingandselling

Candlestick charts

Prices plotted as candles and wicks. Candlebodyindicates Open/CloseorLastprices; wickindicates High/ Lowprices.

If Close or La st price is

lowerthan Open price,then th e cand le is black

If Close or La st price is

higherthan Open price,then th e cand le is whiteor red

High

Low

Close

Open

High

Low

Open

Close

Chart types

High

Low

Close or L ast

Open

Price

Open interest

Market

Strong

Warn ing sign

Weak

Warn ing sign

Price

Volume

Market

Strong

Warn ing sign

Weak

Warn ing sign

Market behaviour

Demand exceeding supply

Supply exceeding demand

Supply and demand in balance

Point and figure chart

Long up columns Xs

Long down columns Os

Short up and down columns

moving sideways

Chart typesSection 2ooxoxooxooxo


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53

oxooxooxo

Further resources

Books

Japanese Candlestick Charting TechniquesSteve Nison , New York Institute of Fina nce , 1991

ISBN 0 1393 1650 7

Candlestick Charting ExplainedGregory Morris, Probus Publishing Co., 1995

ISBN 1 55738 891 1

Study Help for Point & Figure TechniquesAlexand er Wheelan , Fraser P ublishing, 1990

ISBN 0 8703 4091 3

Technical Analysis of Stocks and Commodities

Technical analysis of volumeby H .K. Waxen bergVol. 4:2 (65-68), 1986

Point and Figure Chartingby G. van Po wellVol. 11:1 (30-33), 1993

Candlesticks and Intraday Market Analysisby G.S. Wagner & B.L

MathenyVol. 11:4 (169-173), 1993


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PatternsSection 3


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55

Contents

57

60

62

66

72

76

80

82

85

87

87

88

89

90

12

3

6

9

12

4

578

1110

This section of the module should take about 2

ho urs of study time. You m ay not take as long a s

this or it may take a little longer remember

your learning is individual to you.

Introduction

Trendlines

Continuation/consolidation patterns

Reversal patterns

Support and resistance linesMoving averages

Relative performance

Gaps

Charting exercises

Summary


Overview

Further resources

Quick quiz answers

Section 3Patterns


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56

The longer a trendline is in effect and the more data points that

are used to establish the line, the greater the significance is.Significant penetration of the trendline usually indicates a reversalor a slowing of the trend.

On Trendlines, M oney Flow Index and the Ell iott Wave by Bri an D.Green


PatternsSection 3

Introduction Sideways market This situatio n a rises when th ere is no


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57

Introduction

Cha rting the ma rket beha viour of any particular finan cial

instrument may be considered to be the result of a bat tle between

buyers bulls an d sellers bears. Market prices do n ot m ove in a

straight line bu t zig-zag as prices rise an d fa ll depend ing on who is

winning the buyer/seller ba ttle. In ord er to help market players

decide if they should buy or sell they need tools to help decide their

trad ing strategy. On e such tool is the market trendan d is simplydefined a s:

The di rection of the market the way the market i s moving.

There a re two basic trenddirections and the situation when amarket is within a sideways consolidationto con sider:

Uptrend This is con sidered to be the tim e to buyorgo long. A major up tren d is alsoknown as a Bullmarket. Market playershave the oppor tunity to profit by being

bullish buying a nd staying with th euptrend.

Downtrend This is con sidered to be the tim e to sellorgo short. A major d owntrend is alsoknown as a Bearmarket. Market playershave the oppor tunity to profit by being

bearish selling with a view to bu yinglater. In eq uity markets it is no t always

possible for nor mal

investors to be short they

are either in or out of the

market.

Sideways market This situatio n a rises when th ere is nostrong conviction by either bulls or

bears. As a result market prices rise an d

fall in a mo re congested space hence

the term congestionorconsolidationissometimes used. This type of pa ttern is

generally considered to b e a signal to

stay out of th e mar ket. However, some

trad ers use congestion patter ns as an

opportun ity for rangetrading sellingon th e high side of the con gestion an d

buying b ack and reversing long a t thelow side.

Within th e zig-zag tren d pa ttern s you may also see tempor ar y

corrections in price movements these are known as pullbacks.

You h ave already been in trod uced to market sayings such a s

and as long as the tren d is intact the situation is stable.

The trend is your friend

Go with the trend

The markets

Themarkets

Sideways pat tern s eventu ally result in a breakoutan d reversal orcontinuat ion of th e original trend. Reversals and continuation s have

chara cteristic pattern s which th e cha rtist uses to ma ke trading

decisions. However, these patt ern s are not always easy to reco gnise!

Range

Section 3Patterns

Whilst the situa tion is stab le if you loo k carefully at the zig-zag


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58

Both of the lines boun ding a ch ann el can be viewed as retaining

walls a gainst which prices keep hitting an d b ouncing o ff. In a n

uptrending channel if the lowercha nnel line is broken then thismay warn of a possible reversal of the uptren d. If the upperchannelline is broken then this suggests an a cceleration and strength ening

of the uptrend . In the case of a downtrend it is breach of th e upper

chan nel line tha t warns that the existing trend ma y be ending.

What is actually happening during these ups and downs in the zig-

zag patt erns? The pa tterns are ca used b y the constant battle between

bulls and bears in the market place. At market peaks the bears gain

ascendancy and take control, whilst in th e troughs the situation is

reversed and the bulls gain ascendancy. If market players move to

stop a price fall, then they buy and provide support to the ma rket. If

they move to stop a p rice rise, then they sell and resistanceto therise is the outco me.

Ob serving how ma rkets react to support and resistance is a go od

barom eter of the measure of an und erlying trend.

In a ny market there will be short, medium a nd long -term tren ds. In

some cases all these trend s work in th e same direction resulting in a

strongly trending market. In o ther ca ses the different trend s conflict

with ea ch oth er which results in a much mo re subdued ma rket price

action. The essence of using trend s for both long term investors and

short ter m traders is to be ab le to assess when tren ds are likely to

change.

Cha rtists are looking for a trend line to b e broken a breakout. Thisis a signal to examin e cha rts and market events closely. Wha t do the

signals mean?

Has the trendline/channel been broken?

Are prices just fluctuating in th eir chan nel?

Are th ere any pullbacks?

Are prices moving sideways?

Are there any continuation/reversal patterns?

So far the appro ach ta ken in considering patterns has only

concerned trends. What would Dow have had to say about such an

approach?

Lower

channel l ine

Upperchannel l ine

Resistance

Support

Whilst the situa tion is stab le if you loo k carefully at the zig zag

pattern of a trend you may notice that it is possible to draw two

more or less parallel lines one joining the high points of the peaks

and the oth er the lower points. These lines boun d wha t is known a s

a trend channel.

Uptrendchannel

Downtrendchannel


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Section 3Patterns

Trendlines


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A trendline is a line conn ecting consecutive high o r low data pointsin ord er to identify the direction o f a ma rket. The longer a nunbro ken trend line can be d rawn the more significant th e trend.??Trend lines are used to iden tify the following cha racteristics inmarket trends:

Direction of the trend Reversal of a trend Continuation of a trend

Support an d resistan ce

On ce a trend line is broken it is an early signal of a trend ch angean d sideways movemen t in pr ices it is not necessarily a signal toimmed iately buy or sell.

UptrendThis is a line d rawn joining lowdata points. It is drawn under th elow points and connects at least three consecutive rising low points.Classically the line does not cross any other data points but recent

research shows this is permissible under certain conditions.

DowntrendThis is a line d rawn joining highda ta points. It is dra wn aboveth ehigh points and connects at least three consecutive falling highpoints. Classically the line does not cross any oth er da ta po ints butrecent research shows this is permissible under certain conditions.

Reversal

This is when the validity of the current trend ends and the trend lineis broken. Immediately following a reversal it is quite common forthe m arket to m ove sideways. H owever, there a re instances wherethe end of a tren d is followed by a violent and strongly trendingmarket in an opposite direction to the original trend .

Continuation/consolidationPrices often fluctuate ba ck and fo rth to wards the trend line givingrise to a number of patter ns such a s pennants an d trian gles. Thesideways trend produced is generally an indication of a temporar y

pause in the prevailing trend .

For an uptrend the li ne isdrawn below the data points.Consecutive low points must behigher than the previous point,for example, 2 i s higher than 1.

1

2

3

Uptrend

For a downtrend the line isdrawn above the data points.

Consecut ive high poin ts must belower than the previous point,for example, 2 i s lower than 1.

1

2

3

Downtrend

HeadLeftshoulder

Rightshoulder A common reversal showing a

head and shoulders pattern

A flat top tri angleconti nuation pattern

Tradi tionall y, in uptrends anddowntrends the line does not crossany other data points. However,new research is int roducingconcepts on trendl ines andchannels that permi t this.

PatternsSection 3

Trendlines


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A l ine char t of dai ly closing prices forReuter Holdings shares

A l ine chart of dai ly bid pri ces for theI tali an L ira against the US Dollar

Uptrend line the more times the charthi ts the li ne and the longer the li ne themore reliable the trend

Downtrend line the more times thechart hi ts the li ne and the longer theline the more reliable the trend

Section 3Patterns



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Continuation patternsoccur during periods of consolidationwhen

prices are moving sideways following an up or down trend. Thepattern s are not a lways easy to recogn ise an d d o n ot a lways have theregular shapes described b elow! Co ntinuation pattern s have nam esbased on geometric shapes:

Triangles Rectangles Flags and pennants

Con tinuation pa tterns last for varying periods of time flags andpennants only last a few days, rectangles can last up to a year.

??

Market players use continua tion patt erns to determ ine a target pricefor their tr ad ing strat egy. This targ et price is the level they expectthe mar ket to reach following breakout of the con solidation an dresumption of the continuation trend.

Triangles

These occur in both up a nd d own trends and represent a ba ttlebetween buyers and sellers. Triangles can have flat tops, flat bottomsor sloping sides as with an equilateral triang le. For example, in t his

triangle the flat top indicates that thesellers think tha t th e price is the full value,whereas the buyers are putting in ord ersfor h igher an d h igher prices. Eventuallyone side will win and a breakout will occur.

It is interesting that the closer the pricegets to the apex o f the trian gle the lessreliable the pat tern b ecomes.

It is common to see that the breakout of a triangle following anuptrend gives rise to a short, sharp rise before a price fall occurs.Such breakouts are referred to as Bull trapsand quite often markmajor bull market tops. In a downtren ding m arket the inversesituation is called a Bear trapwhich often mar ks a ma jor bear

market bottom.

Ideall y, as a minimum, thereshoul d be three poin ts of contacton each side of the tri angle.

Flat toptriangle

The target price for each tri angleis taken when the pricedi fference for x = y. M arketplayers then decide their strategy.Long term investors may just

use the pattern to confi rm atrend whil st short term tradersmay decide to buy/ sell at thissignal.

Flat bottomtriangle

Equilateraltriangle

x

x

x

y

y

y

Sell ers think this isfull value

Buyers pr icesgoing higher

Apex

A Bull trap

A Bear trap


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Section 3Patterns



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Bar chart of dai ly last trade pri ces for CBOT US T-Bond futu res, December1996

Equilateraltriangle

Bar chart of dail y prices for Ni kkei 225 Index

Equilateral triangle

Bar chart of daily prices for GBP against USD Line chart of daily close Shenzen 3 month Copper futures prices

Flag

Rectangle

PatternsSection 3



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A candlesti ck chart of dai ly bid prices forDEM / JPY cross rate

Peri ods of conti nuati on are indicated byprice action between the lines shown in red

on the char ts

A weekly bar chart of last trade valuesfor the DAX Index

Section 3Patterns

Reversal patterns


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A reversal pattern, as the na me implies, indicates a top o r bott om in

market prices usually accompanied by a trend reversal. Some of thepatterns are relatively easy to identify and reliable in their

interpretation o thers are more complex. Reversal patter ns are on ly

importan t if they occur in a strong a nd ma rked current up or down

trend. A pattern ob served in a d owntrend is theinverse, or mirrorimage, of tha t seen in a n uptren d a lthough it is not always as

prominent. The most common pattern s which indicate ma rket

reversal a re:

Head and shoulders

Double and triple tops/bottoms

Wedges

Rounding or saucer top/bottom also known a s scalloped

??

Market players use reversal patterns to identify top and bottom price

structures and select target prices for subsequent breakouts and

reversals in m arket tren ds. To help estab lish a target price a chartist

will dra w a necklinewhich, in a head and shoulders pattern, is a linejoining certain specified low points of th e pattern .

Head and shouldersThis patter n is made up of th ree peaks. The cen tre pea k is higher

then th e outer two which are approximately the same h eight the

shape is supposed to resemble someone shrugging. The pattern

usually occurs at th e end o f a long uptren d a nd is one of t he most

common and reliable of pattern s. The left shoulder a nd h ead

represent th e struggle between buyers andsellers and high volumes are tra ded. On

the appeara nce of the right shoulder the

volume declines and if the support line

the neckline is broken, t hen this is a

strong indication t hat prices will continue

in that direction. Interestingly an inverse

head and shoulders, in an eq uity market, is

often less pronoun ced and flatter than

seen in an uptrend .

The neckli ne can be horizontal or slan t upor down. M ore signi fi cance is attached toan upward sloping neckli ne in an uptrendthan a downsloping one.

Once prices breakthrough the neckli nethe target price for market players to take

profi t on positi ons taken at the breakoutcan be determined using the pri cedi fference x = y. This technique assumesthat the price moved at least y prior tothe emergence of the pattern.

Head and shoulders

Inverse head and shoulders

y

x

x

y

Neckline

Leftshoulder

Rightshoulder

Head

HeadLeftshoulder

Rightshoulder

x

y

PatternsSection 3

Reversal patterns


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Double and triple tops/bottoms

Double and triple tops and bottoms are successive peaks andtroughs, of approximately the same height a nd depth, which

represent th e continuing struggle of buyers and sellers to dom inate

the m arket. The pa tterns usually signal intermed iate or long ter m

changes in the trend. Eventually buyers or sellers win and the trend

is reversed .

A do uble to p loo ks like th e letter M a do uble bo ttom a W. Triple

tops and bo ttoms resemble a head and shoulders but do not h ave

such a pronounced head.

Double an d triple tops/bottoms can b e distinguished fro m head

and shoulders pattern s by looking at volumes, for example, the

number of shares being traded . In double and triple tops/bottoms

the volumes usually decrease for each pea k whereas in a head and

shoulders pattern the volume of right shoulder no rmally chan ges

dramatically.

For a doub le top a neckline is dra wn through the mid-point of th e

M as the support level.

Care is needed in using d ouble and triple

tops/bottoms as you need to be confident th at

the previous trend has been reversed. For

example, two double top for mations following

each other could form part o f a rectangular

continuation pattern. It is worth noting thatdoub le and triple tops/bottoms need no t have

exactly equidistant peaks and troughs. Also the

peaks and troughs can be d eep or shallow, though major tops and

bottom s are usually assciated with a deep con solidation area.

In general double tops/bottoms occur more often than head and

shoulders or triple tops/bottoms. However, the likelihood of a full

reversal is greater with head and shoulders and triple tops/bottoms.

The neckli ne can be horizontal or slan t upor down sli ghtly.

Once prices breakthrough the neckli ne the targetlevel for the reversal can be determined takingthe price di fference x = y.

Double top

Double bottom

Triple top

Triple bottom

y

x

y

x

x

y

x

y

M shape

W shape

Section 3Patterns

Reversal patterns


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Wedges

Triangles and wedges define converging prices before a reversal andcan take several weeks or mo nth s to develop. These patter ns are

taken as signa ls as an opportun ity to profit.

Wedgeshave bound aries that gen tly slopetowards each o ther. Wedges can riseorfallslope up o r do wn. Just as with trian gles, a

wedge breakout should o ccur before the apex

of the wedge is reached.

Rounding or saucer tops/bottomsThese are not common types of reversal patterns. They tend to form

slowly over a period of mon ths indicating a protracted struggle

between buyers and sellers with neither really gaining ascendancy.

A round ing top is roughly shaped like an um brella canopy whereas a

round ing botto m h as a saucer shape. These patterns offer no clear-

cut buy or sell signals but when considered in conjunction with

funda menta l ana lysis, chartists can use them to predict long term

investment opportunities.

Roundingtop

Roundingbottom orscalloped

Umbrell a canopy

Saucer

Wedge

Ascendingwedge

PatternsSection 3

Reversal patterns


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A bar chart of last trade weekly Ni kkei 225Index values

Double top

Inverse head andshoulders

Leftshoulder

Rightshoulder

Slopingneckline

Head

A bar chart of dail yGBP/USD prices

Section 3Patterns

Reversal patterns


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Bar chart of dail y prices for DAX Index

Ascending wedge

Bar chart of dai ly prices for USD/ DKK

Bar char t of dai ly last trade pri ces for CBOT US T-Bond fu tu res forDecember 1996

Double bottom

Double top

Bar char t of dai ly last trade pri ces for M icrosoft shares

Rounding orsaucerbottom

PatternsSection 3

Reversal patterns


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A bar chart of daily bid GBP/DEMcross rate prices

Double top



Double top

Double top

A bar chart of last trade LIFFE3-month Swiss Franc interestrate fu tu res for December 1996

Sometimes the patterns are not qui teclassical in appearance

Section 3Patterns

Support d resistancelines f th b i t f

Support and resistance lines


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Supportandresistance linesare on e of the basic componen ts of

charting and are important in the understanding of trends and theirassociated patterns such as continuations and reversals.

Support levelThis is the level tha t supports market price action fo r a per iod o f

time. It is the level where buying interest is stron g eno ugh to

overcome selling pressure. The result is tha t the m arket does not fa ll

below tha t level.

Resistance levelThis is the oppo site of suppo rt a nd is the level tha t resists market

price actio n for a per iod o f time. It is the level where selling interest

is strong enough to overcome buying pressure so the market does

not exceed that level.

??

Support and resistance lines are used by traders involved with both

short an d long -term timescales, for examp le, futures traders and

trad ers in th e eq uities markets. The per forma nce of price action

when support and resistance levels are approached is investigatedclosely by an alysts for signa ls of con tinua tion o r a reversal of the

previous trend.

If prices have been in an uptrend and then fall, breaking an

impor tan t support level in th e process, then this is taken a s a

warning of a trend reversal.

If a resistance level has been tested a nd not broken, then this is

usually taken as an early warn ing of a possible trend cha nge.

Sellingovercomesbuying

Support and resistance levels

Buyingovercomesselling

Resistance level

Support level

Prices in an uptrend

Support level

Pri ces break thesupport level

Resistance level

I f the resistance level is notbroken the previ ous supportmay be chall enged which mayresul t i n a trend change

PatternsSection 3

Support/resistance reversal



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Support/resistance reversal

When a suppor t level is broken then the level takes on the new roleof resistance and when a resistance level is penetrated it takes on the

new role of support.

Open interest Future marketsThere is a relatio nship between suppo rt and resistance levels in a n

uptrend/d owntrend. As a m arket moves away from support/

resistance, that is, new buyers/sellers are entering the market then

the open interest should increase. H owever, if such an increase isnot observed, th en this is taken as a warn ing signal.

Resistance

Resistance levelpenetrated so li nebecomes support

Support

Support levelbroken so linebecomesresistance

Buying here is not

wise as pri ces arefalling

Buying here is goodas prices are ri sing

Example of support/resistance reversalA gold trader buys at $350 at A and sells his position

at $400 the resistance level, B. The market slides

back to C, th e support level at $360, an d th en rises

q uickly to D at $425. When should th e trader b uy?

A popu lar pr ice to buy back is at the $400 level the

previous resistan ce level which ha s now reversed tobecom e th e new support level. Ho wever, a sensible

trader wou ld h ave a stop loss level benea th the $400

level in case the expected support level failed to ha lt

the d owntrend in prices.

A$350

C$360

$400B

D $425

Resistancelevel New support level

ideal pl ace to buy

Support level

Section 3Patterns

Retracement



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Retracement

As a market reacts or rallies following a strongly trending move, partof th at p rice move is retraced this is known as retracement. If theamoun t of retracement can b e predicted then tra ding levels can be

set to a tra ders advantage. C hartists usepercentage retracementstodetermine support a nd resistance levels. Quite often a correction in

a t rending market will retrace to approximately half or 50% of th e

previous move and so this figure is favoured by many traders. Other

common retracements in a bull trend are a pproximately 33% and

66%.

As you will see in t he la ter section on Waves, numbers and cyclesGann

cha rts and Elliott Wave Theo r y pay part icular atten tion to

retracements. G ann lines are often drawn in eighths or tenths and

Elliott Wave Theor y predicts retr acemen t levels at 0.382 (abo ut

33%) a nd 0.618 (a bou t 66%) which a re based on the recipro cals of

the Fibonacci numbers 2.618 and 1.618 respectively.

Percentage retracements

On meeti ngresistance the pri cemoves back retraces towardsthe previoussupport level

Percentageretracements

Resistance level

Support level

33%50%

66%

100%

PatternsSection 3



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A bar char t of weekly Laserscopeshare prices

50% retracement

A bar chart of dail y bidUSD/ FRF pri ces

61.8%

100%Retracements

Thi s is a good exampl e of a Headand Shoulders pattern with asloping neckli ne

61.8%50%

0%

0%

0%

100%

100%

Section 3Patterns

A moving averageis usually created by add ing a series of closing

Moving averages


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g g g g

prices and th en averagin g the d ata on a period -by-period basis. Asthe period moves on, th e oldest price in t he sequence is droppedand replaced by the current price in the period.

A moving average is a lagging indicator that provides a way ofsmoothing o ut da ta an d which is used to con firm price trends. Theperiod chosen for a moving a verage depend s on the type ofinstrumen t being cha rted the most common periods used are9/10, 18/20, 40/50, 100 and 200 periods. Futures markets tend touse shor ter-term moving averages, for example, 9 an d 18 periods,whereas for long -term investmen t instrum ents, such as equities, 50/

100/200 are m ore po pular per iods. Assuming t ha t the in strumen tbeing charted has a cyclical trading pa ttern, research has shown tha tthe most successful moving average is associated with th e cycleperiod for the instrument. There are thr ee types of moving averageused widely, all having benefits and drawbacks, which are:

Simple Mo ving Average (SMA) Weighted Moving Average ( WMA) Expon entia l Moving Averag e ( EMA)

??

In gen eral all three types of moving average a re used for thefollowing:

To d etect trend directions

To deter mine buy/sell signals

When using moving averages it is important to remember that youneed to examine the relationship between the actual price and themoving average. This means that the plot for a moving average mustappear on the price cha rt using the same X -axis as the instrument

being a nalysed.

The positi on of the moving averageplot can be used to indicate thetrend direction of a market

Trend directions

Prices above

movingaverage

Movingaverage li ne

Prices below

movingaverage

Movingaverage li ne

Bullish

Bearish

Market signal

Bullish

Bearish

Price/moving average relationship

Prices abovemoving a verage an dmoving average moving up

Prices belowmoving a verage an dmoving average moving down

What is the next movingaverage in this sequence?You can check your a nswer

on page 59.

Price 3 day movingaverage

20 21.6721 21.6724 24.0023 23.6725

2320

?

PatternsSection 3

Using classical chart ing techn iques for a single moving average, th e

Moving averages


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signal for buying is taken as the moving average turning upwithprice action abovethe moving average. However, trading using sucha stra tegy can result in severe losses if the m arket pr ices oscillateviolently known as whipsawing . In a n a ttemp t to a void losses,an alysts use a two m oving a verag e crossovertechnique to indicatebuy/sell signa ls. The two m oving averages typically comprise a sho rt-term 5-10 period and a longer-term 15-35 period 9/10 short-terman d 10/20 lon g-term period s are part icularly popular with a na lysts.

The lines are u sually distinguished using d ifferent colours inchart ing applications although solid and dotted lines may be usedfor publications.

Buy an d sell signa ls are in dicat ed a s follows:

If the shor t-term m oving a verag e comes from belowand crossesabovethe lon g-term moving average, th en th is is a buysigna l ifthe price action is abovethe moving a verag e cross-over poin t.

If the shor t-term m oving a verag e comes from aboveand crossesbelowthe lon g-term moving average, th en th is is a sellsigna l ifthe price action is belowthe moving a verag e cross-over poin t.

The crossover is considered to be much more significant if bothaverages are mo ving in th e same direction.

If both averages are moving up, th en it is known a s a Golden Cross.If both averages are moving d own, then it is known as a Death Cross.

Short-term movingaverage

Long-term

moving average

Sell

BuySell

Buy/sell signals

Simple Moving AveragesThis is the type of m oving average which h as alread y been described .It is simply the a

Technical Reuters

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