What is Technical Analysis?

What is Technical Analysis? -- Chart School

SharpChart: Symbol Catalog

You are logged out Log in

You are here: Chart School > What is TA?

Search the Site:

What is Technical Analysis? Advanced Search

Chart School Technical Analysis Overview Chart Analysis Indicator Analysis Market Analysis Trading Strategies Analysis Tools SharpCharts PerfCharts Point & Figure Charts Stock Scans Market Carpet Additional Resources Bookstore Glossary Newsletter Archives Mailbag Articles Using StockCharts.com Recommended Sites

This area of the Chart School explains Technical Analysis, and the tools, indicators and patterns associated with it. Click any link to view that article. Overview-

This section contains articles regarding the basics of investing and Technical Analysis. ● ● ● ●

Trading Strategies-

Why Analyze Securites? A Random Walk Technical Analysis Fundamental Analysis

This section contains articles explaining the trading strategies used by some of our columnists. Contributors include CNBC Analyst John Murphy, and Scott "LastShadow" McCormick. ● ●

●

Join Now! ●

●

John Murphy's Ten Laws Arthur Hill on Goals, Style and Strategy Arthur Hill on Moving Average Crossovers Scott McCormick's Gap Trading Strategies The Pre-Holiday Effect

Our Bookstore Books on: Our Favorites Technical Analysis Books by John Murphy P&F Charting General Investing

http://www.stockcharts.com/education/what/ (1 of 3) [2/18/2003 3:24:44 AM]

●

●

The "Last" Stochastic Technique Richard Rhodes' Trading Rules

What is Technical Analysis? -- Chart School

Indicator Analysis-

This section contains articles explaining what Indicators are, types of indicators used in Technical Analysis, and how they are used. ● ●

● ● ● ●

● ● ● ● ●

Introduction to Indicators Accumulation/Distribution Line Average Directional (ADX) Average True Range (ATR) Bollinger Bands Commodity Channel Index (CCI) Chaikin Money Flow Chaikin Oscillator Moving Averages MACD Percentage Volume Oscillator (PVO)

●

●

●

●

●

●

● ● ● ● ●

Chart Analysis-

Price Oscillator (including PPO) Price Relative Rabbitt QStockRank Relative Strength Index (RSI) Standard Deviation Stochastic Oscillator StochRSI TRIN VIX Williams %R ZigZag

This section contains articles on what charts are, common patterns that appear, and how to interpret them. ● ● ● ●

●

●

●

●

●

●

●

● ●

What are Charts? Trendlines Support and Resistance Introduction to Candlesticks Introduction to Chart Patterns Introduction to Candlesticks Candlesticks and Support Candlesticks and Resistance Candlestick Bullish Reversals Candlestick Bearish Reversals Bump and Run Reversal BARR Double Top Double Bottom

http://www.stockcharts.com/education/what/ (2 of 3) [2/18/2003 3:24:44 AM]

●

● ● ●

● ●

●

●

● ● ●

●

Rounding Bottom Triple Top Triple Bottom Cup with Handle Flag, Pennant Symmetric Triangle Ascending Triangle Descending Triangle Price Channel Rectangle Measured (Bull) Move Measured (Bear) Move

What is Technical Analysis? -- Chart School ● ●

● ●

Market Analysis-

Head and Shoulders Top Head and Shoulders Bottom Falling Wedge Rising Wedge

This section contains articles regarding the basics of investing and Technical Analysis. ● ●

The Dow Theory Elliot Wave Theory

Financial Ad Trader

Join Now! | Newsletter | FAQ | Glossary | Terms of Use Home | Free Charts | Chart School | Members | Support Data provided by: Unless otherwise indicated, all data is delayed by 20 minutes ©1999-2003 StockCharts.com All Rights Reserved

http://www.stockcharts.com/education/what/ (3 of 3) [2/18/2003 3:24:44 AM]

Overview -- Chart School

SharpChart: Symbol Catalog

You are logged out Log in

You are here: Chart School > What is TA? > Overview

Search the Site:

Advanced Search

Overview

Chart School Technical Analysis Overview Chart Analysis Indicator Analysis Market Analysis Trading Strategies Analysis Tools SharpCharts PerfCharts Point & Figure Charts Stock Scans Market Carpet Additional Resources Bookstore Glossary Newsletter Archives Mailbag Articles Using StockCharts.com Recommended Sites

Why Analyze Securities?-

A Random Walk-

Random walk theory jibes with the semi-strong efficient hypothesis in its assertion that it is impossible to outperform the market on a consistent basis.

Technical Analysis-

Technical analysis is the examination of past price movements to forecast future price movements. Technical analysts are sometimes referred to as chartists because they rely almost exclusively on charts for their analysis. Part 1

Join Now! Fundamental Analysis-

Our Bookstore Books on: Our Favorites Technical Analysis Books by John Murphy P&F Charting General Investing

Addresses security analysis and if it matters, whether or not markets are efficient, and forms of analysis.

Part 2

Fundamental analysis is the examination of the underlying forces that affect the interests of the economy, industrial sectors and companies. As with most analysis, the goal is to derive a forecast for the future. Part 1

http://www.stockcharts.com/education/What/Overview/index.html (1 of 2) [2/18/2003 3:25:39 AM]

Part 2

Overview -- Chart School

Financial Ad Trader

Join Now! | Newsletter | FAQ | Glossary | Terms of Use Home | Free Charts | Chart School | Members | Support Data provided by: Unless otherwise indicated, all data is delayed by 20 minutes ©1999-2003 StockCharts.com All Rights Reserved

http://www.stockcharts.com/education/What/Overview/index.html (2 of 2) [2/18/2003 3:25:39 AM]

StockCharts.com - Why Analyze Securities?

Why Analyze Securities?

Security Analysis - Does it Matter?

Wall Street has scores of analysts, strategists and portfolio managers hired to do one thing: beat the market. Analysts are hired to find undervalued stocks. Strategists are hired to predict the direction of the market and various sectors. Portfolio managers are hired to put it all together and outperform their benchmark, usually measured as the S&P 500. Granted, there are many studies and disputes raging on the performance of equity mutual funds, but it is safe to assume that about 75% of equity mutual funds underperform the S&P 500. With these kinds of stats, individual investors would surely be better off simply investing in an index fund rather than attempting to beat the market. But that wouldn't be any fun, would it? After all, half the fun is actually doing the analysis. The added value of analysis is in the eye of the beholder. A fundamental analyst believes that analyzing strategy, management, product, financial stats and many other readily and not-so-readily quantifiable numbers will help choose stocks that will outperform the market. They are also likely to believe that there is little or no value in analyzing past prices and that technical analysts would be better off star gazing. Star gazing! Hmmmmph. The technical analyst believes that the chart, volume, momentum and an array of funny and not-so-funny indicators hold the keys to superior performance. In addition, the technician might add that fundamentals are hogwash pure and simple. There is good news though. The battle between fundamental analysis and technical analysis has been settled by the Random Walk theory. The Random Walkers believe that both are useless as is any attempt to try and outwit the market. So whom do we believe? Is fundamental analysis worth the time and effort? Are technicians a bunch of quacks? Or is it all a lesson in futility? First, it will help to look at the efficient market hypothesis and see where the fundamentalists, technicians and Random Walkers stand on the question of market efficiency. After we have explored this area, we will then take a closer look at the random walk theory, fundamental analysis and technical analysis. Are Markets Efficient?

The question concerning the value of analysis begins with the debate on market efficiency. Just what is represented by the current price of a security? Is a security's current price an accurate reflection of its fair value? Or, do anomalies exist that allow http://www.stockcharts.com/education/What/Overview/analyzeSecurities-print.html (1 of 5) [2/18/2003 3:26:54 AM]

StockCharts.com - Why Analyze Securities?

traders and investors the opportunity to beat the market by finding undervalued or overvalued securities? Aswath Damodaran, of the Stern Business School at NYU, defines an efficient market as one where the market price is an unbiased estimate of the true value of the investment. Fair enough, but it is not quite that simple. In an efficient market, the current price of a security fully reflects all available information and is the fair value. "All" because the price is the sum value of all views (bullish, bearish or otherwise) held by market participants. It is the fair value because the market agreed on a price to buy and sell the security. As new information becomes available, the market assimilates the information by adjusting the security's price up (buying) and down (selling). In an efficient market, deviations above and below fair value are possible, but these deviations are considered to be random. Over the long run, the price should accurately reflect fair value. The hypothesis further asserts that if markets are efficient, then it should be virtually impossible to outperform the market on a sustained basis. Even though deviations will occur and there will be periods when securities are over- or undervalued, these anomalies will disappear as quickly as they appeared, thus making it almost impossible to profit from them. From experience, most of us would agree that the market is not perfectly efficient. Anomalies do exist and there are investors and traders that outperform the market. Therefore, there are varying degrees of market efficiency, which have been broken down into three levels. These three levels also happen to correspond to the beliefs of the fundamentalists, technicians and random walkers. Strong-form: Technicians

The strong-form of market efficiency theorizes that the current price reflects all information available. It does not matter if this information is available to the public or privy to top management; if it exists at all, then it is already reflected in the current price. Because all possible information is already reflected in the price, investors and traders will not be able to find or exploit inefficiencies based on fundamental information. Generally, pure technical analysts believe that the markets are strong-form efficient and all information is reflected in the price.

http://www.stockcharts.com/education/What/Overview/analyzeSecurities-print.html (2 of 5) [2/18/2003 3:26:54 AM]

StockCharts.com - Why Analyze Securities?

Semi-Strong Form: Random Walkers (academics)

The semi-strong form of market efficiency theorizes that the current price reflects all readily available information. This information will likely include annual reports, SEC filings, earnings reports, announcements and other relevant information that can be readily gathered. However, there is other information not readily available to the public that is not fully reflected in the price. This could be information held by insiders, competitors, contractors, suppliers or regulators, among others. Anomalies exist when information is withheld from the public and the only way to profit is by using information not yet known to the public. This is sometimes called insider trading. Once this information becomes public knowledge, prices adjust instantaneously and it is virtually impossible to profit from such news. Academics and Random Walkers believe that the markets are semi-strong efficient. Prices reflect public information and it is virtually impossible to profit from this information. Why do academics believe it is not possible to profit from efficient markets? There is an old joke among economists that relates to market efficiency. Two economists are walking down the street and one spots a $20 bill lying on the ground. He turns to the other economist and says, "Look, a $20 bill". The other economist looks at him in disbelief and answers, "If it were a real $20 bill, someone would have already picked it up". Academics feel that if a security is selling for 10 and one year from now it will be worth 20, what is to keep it from going to 20, or at least 18 immediately? If it were really worth 20 in one year, the price would reflect this today. Weak-form: Fundamentalists

The weak-form of market efficiency theorizes that the current price does not reflect fair value and is only a reflection of past prices. Furthermore, the future price cannot be determined using past or current prices (sorry technical analysts). Fundamental analysts are champions of weak-form market efficiency and believe that the true value of a security can be ascertained through financial models using information readily available. The current price will not always reflect fair value and these models will help identify anomalies. Which Form Exists in the Market Today?

Many in academia, including Gordon Gemmill of London City University Business School and Aswath Damodaran of NYU, believe that security prices are semi-strong efficient. Recall that semi-strong efficient implies that all public knowledge is reflected in the price and it is virtually impossible to exploit deviations from the true value based on public information. Only new information will affect the price. Judging from the reaction of many stocks to news events, there seems to be evidence to support this case. The flow of information has become faster with the internet and surprises are factored in instantly. Few will argue that a surprise, both positive and negative, can violently move http://www.stockcharts.com/education/What/Overview/analyzeSecurities-print.html (3 of 5) [2/18/2003 3:26:54 AM]

StockCharts.com - Why Analyze Securities?

the price of a security. A few examples include: ●

●

After pre-announcing that earnings would come in below expectations on 6-Jan-00, Lucent fell from 73 to 53 in one day. (Current SharpChart for Lucent)

After positive comments from an influential analyst on 23-Feb-00, AOL shot up 49 to 59 in 2 days. (Current SharpChart for AOL)

http://www.stockcharts.com/education/What/Overview/analyzeSecurities-print.html (4 of 5) [2/18/2003 3:26:54 AM]

StockCharts.com - Why Analyze Securities? ●

After reporting earnings that were below expectations on 15-Feb, Abercrombie and Fitch fell from 24 to 15. (Current SharpChart for Abercrombie and Fitch)

Even though these are but a few examples, it is obvious that new information can move the price of a security. Many academics also argue that price movements are largely random and only influenced by the introduction of new information. Many academics do acknowledge that some drift exists in security prices, but never a trend. Random, are prices really random?

Next>

Written by Arthur Hill

Send us your Feedback!

©2002 StockCharts.com All Rights Reserved Terms of Use

http://www.stockcharts.com/education/What/Overview/analyzeSecurities-print.html (5 of 5) [2/18/2003 3:26:54 AM]

StockCharts.com - A Random Walk

A Random Walk A Random Walk Down Wall Street, written by Burton Malkiel in 1973, has become a classic in investment literature. Random walk theory jibes with the semi-strong efficient hypothesis in its assertion that it is impossible to outperform the market on a consistent basis. Malkiel puts both technical analysis and fundamental analysis to the test and reasons that both are largely a waste of time. In fact, he goes to great lengths to show that there is no proof to suggest that either can consistently outperform the market. Any success outperforming the market with technical analysis or fundamental analysis can be attributed to lady luck. If enough people try, some are bound to outperform the market, but most are still likely to underperform. The basic random walk premise is that price movements are totally random. Judging from the chart, the price movements of Newmont Mining over this 5-month period would appear to be quite random. Prices have no memory, therefore past and present prices cannot be used to predict future prices (as implied in technical analysis). Prices move at random and adjust to new information as it comes available. The adjustment to this new information is so fast that it is impossible to profit from it. Furthermore, news and events are also random and trying to predict these (fundamental analysis) is also a lesson in futility. Malkiel maintains that a buy and hold strategy is best and individuals should not attempt to time (or beat) the market. Attempts based on technical, fundamental or any other analysis are futile. Admittedly, he does have a point. Statistics have shown that the majority of equity mutual funds fail to outperform the market, as measured by the S&P 500. Investors can easily buy index-based securities with very low transactions costs. Should random walkers take a hike?

http://www.stockcharts.com/education/What/Overview/randomWalk-print.html (1 of 5) [2/18/2003 3:27:31 AM]

StockCharts.com - A Random Walk

While there are some good points to be gleaned from the random walk theory, it appears to be a bit dated and does not accurately reflect the current investment climate. Random walk theory was introduced over 25 years ago when institutions dominated the market. These institutions had superior access to resources and the individual was at the mercy of the large brokerage houses for quality research. With the advent of online trading, power and influence are shifting from the institutions to the individual. Resources are now widely available to all at minimal cost, if not free. Not only can individuals access information, but the internet ensures that everyone will receive it almost instantaneously. They also have access to real time data and can trade like the pros. With the availability of real time data and almost instant executions, individuals can act on information like never before. As little as 5 years ago, transactions costs were high and figured into any investment or trading strategy. Again, with the advent of online trading, transactions costs have become minimal. This has increased the amount of trading volume and probably volatility. Higher volatility increases the possibility that anomalies will develop. With better trading resources and low commissions, more traders and investors than ever are able to capitalize on potential anomalies. For obvious reasons, the Wall Street establishment is not thrilled about Random Walk theory. After all, Wall Street is in the business of analysis, strategy and money management. However, it is a fact that about 75% of equity mutual funds underperform the S&P 500 year after year. Some of this underperformance can be blamed on transactions cost and management fees. However, with the advent of index-linked securities, the onus will be on the money managers to figure out a way to outperform the market or lose business. In truth, 75% of equity mutual funds underperforming is not as bad as it sounds. When the Random Walk theory was introduced in 1973, or even 15 years ago, around 90% of equity mutual funds underperformed the market. Since this number seems to have risen, it would appear that either stock picking is getting better or fees are getting smaller, or both. 15 years ago, the stock market and mutual funds were much more homogeneous. Even though there were tech stocks, they did not exert nearly as much influence. With the explosion of the Nasdaq, tech stocks play a much larger role in today's market. Internet stocks, which have also come to the forefront, did not even exist 15 years ago. With an increase in specialty mutual funds catering to tech and internet, the total number of mutual funds has proliferated over the last few years. With the increase in mutual funds has also come and increase in the diversity of such funds. There are funds for almost every sector, industry or index imaginable and investors have a wide array of choices. The more homogeneous mutual funds there are, the less chance there is to outperform. However, this specialization has created a hierarchy among mutual funds and helped to increase the percentage funds that outperform the S&P 500 from 10% to 25%. http://www.stockcharts.com/education/What/Overview/randomWalk-print.html (2 of 5) [2/18/2003 3:27:31 AM]

StockCharts.com - A Random Walk

History has proven that a buy and hold strategy outperforms most attempts to time the market in absolute returns. In risk-adjusted returns, the argument looses some of its credibility. Buy and hold may take the guesswork out of beating the market, but it does little to compensate for the risk associated with a continuous investment in the market. There is a direct correlation with risk and return: the higher the expected return, the higher the associated risk. A portfolio with a timing strategy that seeks to move into riskfree treasuries when a bear market is signaled (Dow Theory for example), significantly reduces the amount of risk associated with that portfolio.

The New York Times on 6-Sept-98, notes a study that was published in the Journal of Finance by Stephen Brown of New York University and William Goetzmann and Alok Kumar of Yale. The Dow theory system was tested against buy-and-hold for the period from 1929 to Sept-98. Over the 70-year period, the Dow theory system outperformed a buy-and-hold strategy by about 2% per year. In addition, the portfolio carried significantly less risk. If compared as risk-adjusted returns, the margin of outperformance would even be greater. Over the past 18 years, the Dow theory system has underperformed the market by about 2.6% per year. However, when adjusted for risk, the Dow theory system outperformed buy-and-hold over the past 18 years. Keep in mind that 18 years is not a long time in the history of the market. A Non-Random Walk Down Wall Street

There is another school of thought that considers the markets efficient yet predictable. One of the leading proponents is Andrew Lo. Lo earned his Ph.D in economics at the http://www.stockcharts.com/education/What/Overview/randomWalk-print.html (3 of 5) [2/18/2003 3:27:31 AM]

StockCharts.com - A Random Walk

University of Chicago and is currently a Professor of Finance at the Sloan School of Management at MIT. Lo is a bit of an odd ball among academics because of his beliefs regarding the efficient market hypothesis and his attraction to technical analysis. Lo and Mackinlay's book A Non-Random Walk Down Wall Street debunks many of the theories put forth in the 1973 classic with a similar name. (Remember that most academics subscribe to the random walk theory.) Lo's research concluded the following:

Financial markets are predictable to some degree, but far from being a symptom of inefficiency or irrationality, predictability is the oil that lubricates the gears of capitalism. (Current Chart for TXN)

It is not only plausible that markets are efficient, but participants can also profit from efficient markets. However, Lo asserts that even though it is possible to outperform the markets, it requires ongoing research, continuous improvement and constant innovation. Beating the market does not come easy, nor is it something that is easy to maintain. Lo likens the pursuit of above-average returns to that of a company trying to maintain its competitive advantage. After introducing a hot new product, a company cannot just sit back and wait for the money to roll in. In order to remain above the competition, management must be flexible and look for ways to continuously improve and innovate. Otherwise the competition will overtake them. Money managers, traders and investors who find ways to outperform the market must also remain flexible and innovative. Just because a method works today, does not mean it will work tomorrow. In an interview with Technical Analysis of Stocks and Commodities, Lo sums it up by stating: "The more creativity you bring to the investment process, the more rewarding it will be. The only way to maintain ongoing success, however, is to constantly innovate. That's much the same in all endeavors. The only way to continue making money, to continue growing and keeping your profit margins healthy, is to constantly come up with new ideas."

http://www.stockcharts.com/education/What/Overview/randomWalk-print.html (4 of 5) [2/18/2003 3:27:31 AM]

StockCharts.com - A Random Walk

Conclusions

These rebuttals to random walk theory are not meant to suggest that the vast majority of individuals are going to suddenly start outperforming the market. Even though this may be true over the past 3 years, history suggests that it is not likely to be the case 10 years from now. In other words, history suggests that this is an anomaly and there will be a reversion to the mean. Nonetheless, the investment and trading landscape has changed drastically over the last 20 years, even over the last 5 years. Individuals have access to more information and tools, transactions costs are negligible, trades are executed almost instantaneously, equity mutual funds have improved their performance and the buy and hold strategy does not appear to be a profit maximizing strategy. It should come as no surprise that analysis can make a difference. The only question is which type: fundamental analysis, technical analysis or both?

Written by Arthur Hill

Next>

Send us your Feedback!

©2002 StockCharts.com All Rights Reserved Terms of Use

http://www.stockcharts.com/education/What/Overview/randomWalk-print.html (5 of 5) [2/18/2003 3:27:31 AM]

StockCharts.com - Technical Analysis - Part 1

Technical Analysis - Part 1

What is Technical Analysis?

Technical analysis is the examination of past price movements to forecast future price movements. Technical analysts are sometimes referred to as chartists because they rely almost exclusively on charts for their analysis.

http://www.stockcharts.com/education/What/Overview/techAnalysis1-print.html (1 of 7) [2/18/2003 3:28:05 AM]

StockCharts.com - Technical Analysis - Part 1

(Current Chart for Xircom) Technical analysis is applicable to stocks, indices, commodities, futures or any tradable instrument where the price is influenced by the forces of supply and demand. Price refers to any combination of the open, high, low or close for a given security over a specific timeframe. The time frame can be based on intraday (tick, 5-minute, 15-minute or hourly), daily, weekly or monthly price data and last a few hours or many years. In addition, some technical analysts include volume or open interest figures with their study of price action.

The Basis of Technical Analysis

At the turn of the century, the Dow Theory laid the foundations for what was later to become modern technical analysis. Dow Theory was not presented as one complete amalgamation, but rather pieced together from the writings of Charles Dow over several years. Of the many theorems put forth by Dow, three stand out: ● ● ●

Price Discounts Everything Price Movements are not Totally Random What is More Important than Why

Price Discounts Everything: This theorem is similar to the strong and semi-strong forms of market efficiency. Technical analysts believe that the current price fully reflects all information. Because all information is already reflected in the price, it represents

http://www.stockcharts.com/education/What/Overview/techAnalysis1-print.html (2 of 7) [2/18/2003 3:28:05 AM]

StockCharts.com - Technical Analysis - Part 1

the fair value and should form the basis for analysis. After all, the market price reflects the sum knowledge of all participants, including traders, investors, portfolio managers, buy-side analysts, sell-side analysts, market strategist, technical analysts, fundamental analysts and many others. It would be folly to disagree with the price set by such an impressive array of people with impeccable credentials. Technical analysis utilizes the information captured by the price to interpret what the market is saying with the purpose of forming a view on the future. Prices Movements are not Totally Random: Most technicians agree that prices trend. However, most technicians also acknowledge that there are periods when prices do not trend. If prices were always random, it would be extremely difficult to make money using technical analysis. In his book, Schwager on Futures: Technical Analysis, Jack Schwager states: "One way of viewing it is that markets may witness extended periods of random fluctuation, interspersed with shorter periods of nonrandom behavior. The goal of the chartist is to identify those periods (i.e. major trends)."

(Current Chart for IBM) A technician believes that it is possible to identify a trend, invest or trade based on the trend and make money as the trend unfolds. Because technical analysis can be applied to many different timeframes, it is possible to spot both short-term and long-term trends. The IBM chart illustrates Schwager's view on the nature of the trend. The broad trend is up, but it is also interspersed with trading ranges. In between the trading http://www.stockcharts.com/education/What/Overview/techAnalysis1-print.html (3 of 7) [2/18/2003 3:28:05 AM]

StockCharts.com - Technical Analysis - Part 1

ranges are smaller uptrends within the larger uptrend. The uptrend is renewed when the stock breaks above the trading range. A downtrend begins when the stock breaks below the low of the previous trading range. What is more Important than Why: iIn his book, The Psychology of Technical Analysis, Tony Plummer paraphrases Oscar Wilde by stating, "A technical analyst knows the price of everything, but the value of nothing". Technicians, as technical analysts are called, are only concerned with two things: 1. What is the current price? 2. What is the history of the price movement? The price is the end result of the battle between the forces of supply and demand for the company's stock. The objective of analysis is to forecast the direction of the future price. By focusing on price and only price, technical analysis represents a direct approach. Fundamentalists are concerned with why the price is what it is. For technicians, the why portion of the equation is too broad and many times the fundamental reasons given are highly suspect. Technicians believe it is best to concentrate on what and never mind why. Why did the price go up? It is simple, more buyers (demand) than sellers (supply). After all, the value of any asset is only what someone is willing to pay for it. Who needs to know why?

General Steps to Technical Evaluation

Many technicians employ a top-down approach that begins with broad-based macro analysis. The larger parts are then broken down to base the final step on a more focused/micro perspective. Such an analysis might involve three steps: 1. Broad market analysis through the major indices such as the S&P 500, Dow Industrials, Nasdaq and NYSE Composite. 2. Sector analysis to identify the strongest and weakest groups within the broader market. 3. Individual stock analysis to identify the strongest and weakest stocks within select groups. The beauty of technical analysis lies in its versatility. Because the principles of technical analysis are universally applicable, each of the analysis steps above can be performed using the same theoretical background. You don't need an economics degree to analyze a market index chart. You don't need to be a CPA to analyze a stock chart. Charts are charts. It does not matter if the timeframe is 2 days or 2 years. It does not matter if it is a stock, market index or commodity. The technical principles of support, resistance, trend, trading range and other aspects can be applied to any chart. While this may sound easy, technical analysis is by no means easy. Success requires serious study,

http://www.stockcharts.com/education/What/Overview/techAnalysis1-print.html (4 of 7) [2/18/2003 3:28:05 AM]

StockCharts.com - Technical Analysis - Part 1

dedication and an open mind.

Chart Analysis

Technical analysis can be as complex or as simple as you want it. The example below represents a simplified version. Since we are interested in buying stocks, the focus will be on spotting bullish situations.

http://www.stockcharts.com/education/What/Overview/techAnalysis1-print.html (5 of 7) [2/18/2003 3:28:05 AM]

StockCharts.com - Technical Analysis - Part 1

(Current Chart for Intuit) Overall Trend: The first step is to identify the overall trend. This can be accomplished with trendlines, moving averages or peak/trough analysis. As long as the price remains above its uptrend line, selected moving averages or previous lows, the trend will be considered bullish. Support: Areas of congestion or previous lows below the current price mark support levels. A break below support would be considered bearish. Resistance: Areas of congestion and previous highs above the current price mark the resistance levels. A break above resistance would be considered bullish. Momentum: Momentum is usually measured with an oscillator such as MACD. If MACD is above its 9-day EMA (exponential moving average) or positive, then momentum will be considered bullish, or at least improving. Buying/Selling Pressure: For stocks and indices with volume figures available, an indicator that uses volume is used to measure buying or selling pressure. When Chaikin Money Flow is above zero, buying pressure is dominant. Selling pressure is dominant when it is below zero. Relative Strength: The price relative is a line formed by dividing the security by a benchmark. For stocks it is usually the price of the stock divided by the S&P 500. The plot of this line over a period of time will tell us if the stock is outperforming (rising) or underperforming (falling) the major index. The final step is to synthesize the above analysis to ascertain the following: ● ● ● ●

Strength of the current trend. Maturity or stage of current trend. Reward to risk ratio of a new position. Potential entry levels for new long position.

Top-Down Technical Analysis

For each segment (market, sector and stock), an investor would analyze long-term and short-term charts to find those that meet specific criteria. Analysis will first consider the market in general, perhaps the S&P 500. If the broader market were considered to be in bullish mode, analysis would proceed to a selection of sector charts. Those sectors that http://www.stockcharts.com/education/What/Overview/techAnalysis1-print.html (6 of 7) [2/18/2003 3:28:05 AM]

StockCharts.com - Technical Analysis - Part 1

show the most promise would be singled out for individual stock analysis. Once the sector list is narrowed to 3-4 industry groups, individual stock selection can begin. With a selection of 10-20 stock charts from each industry, a selection of 3-4 of the most promising stocks in each group can be made. How many stocks or industry groups make the final cut will depend on the strictness of the criteria set forth. Under this scenario, we would be left with 9-12 stocks from which to choose. These stocks could even be broken down further to find the 3-4 of the strongest of the strong.

Written by Arthur Hill

Part 1 | Part 2

Send us your Feedback!

©2002 StockCharts.com All Rights Reserved Terms of Use

http://www.stockcharts.com/education/What/Overview/techAnalysis1-print.html (7 of 7) [2/18/2003 3:28:05 AM]

StockCharts.com - Technical Analysis - Part 2

Technical Analysis - Part 2

Strengths of Technical Analysis

Focus on Price: If the objective is to predict the future price, then it makes sense to focus on price movements. Price movements usually precede fundamental developments. By focusing on price action, technicians are automatically focusing on the future. The market is thought of as a leading indicator and generally leads the economy by 6 to 9 months. To keep pace with the market, it makes sense to look directly at the price movements. More often than not, change is a subtle beast. Even though the market is prone to sudden knee-jerk reactions, hints usually develop before significant moves. A technician will refer to periods of accumulation as evidence of an impending advance and periods of distribution as evidence of an impending decline. Supply, Demand, and Price Action: Many technicians use the open, high, low and close when analyzing the price action of a security. There is information to be gleaned from each bit of information. Separately, these will not be able to tell much. However, taken together, the open, high, low and close reflect forces of supply and demand.

http://www.stockcharts.com/education/What/Overview/techAnalysis2-print.html (1 of 4) [2/18/2003 3:28:25 AM]

StockCharts.com - Technical Analysis - Part 2

The annotated example above shows a stock that opened with a gap up. Before the open, the number of buy orders exceeded the number of sell orders and the price was raised to attract more sellers. Demand was brisk from the start. The intraday high reflects the strength of demand (buyers). The intraday low reflects the availability of supply (sellers). The close represents the final price agreed upon by the buyers and the sellers. In this case, the close is well below the high and much closer to the low. This tells us that even though demand (buyers) was strong during the day, supply (sellers) ultimately prevailed and forced the price back down. Even after this selling pressure, the close remained above the open. By looking at price action over an extended period of time, we can see the battle between supply and demand unfold. In its most basic form, higher prices reflect increased demand and lower prices reflect increased supply. Support/Resistance: Simple chart analysis can help identify support and resistance levels. These are usually marked by periods of congestion (trading range) where the prices move within a confined range for an extended period, telling us that the forces of supply and demand are deadlocked. When prices move out of the trading range, it signals that either supply or demand has started to get the upper hand. If prices move above the upper band of the trading range, then demand is winning. If prices move below the lower band, then supply is winning. Pictorial Price History: Even if you are a tried and true fundamental analyst, a price chart can offer plenty of valuable information. The price chart is an easy to read historical account of a security's price movement over a period of time. Charts are much easier to read than a table of numbers. On most stock charts, volume bars are displayed at the bottom. With this historical picture, it is easy to identify the following: ● ● ● ●

Reactions prior to and after important events. Past and present volatility. Historical volume or trading levels. Relative strength of a stock versus the overall market.

Assist with Entry Point: Technical analysis can help with timing a proper entry point. Some analysts use fundamental analysis to decide what to buy and technical analysis to decide when to buy. It is no secret that timing can play an important role in performance. Technical analysis can help spot demand (support) and supply (resistance) levels as well as breakouts. Simply waiting for a breakout above resistance or buying near support levels can improve returns. It is also important to know a stock's price history. If a stock you thought was great for the last 2 years has traded flat for those two years, it would appear that Wall Street has a different opinion. If a stock has already advanced significantly, it may be prudent to wait for a pullback. Or, if the stock is trending lower, it might pay to wait for buying interest and a trend reversal.

http://www.stockcharts.com/education/What/Overview/techAnalysis2-print.html (2 of 4) [2/18/2003 3:28:25 AM]

StockCharts.com - Technical Analysis - Part 2

Weaknesses of Technical Analysis

Analyst Bias: Just as with fundamental analysis, technical analysis is subjective and our personal biases can be reflected in the analysis. It is important to be aware of these biases when analyzing a chart. If the analyst is a perpetual bull, then a bullish bias will overshadow the analysis. On the other hand, if the analyst is a disgruntled eternal bear, then the analysis will probably have a bearish tilt. Open to Interpretation: Furthering the bias argument is the fact that technical analysis is open to interpretation. Even though there are standards, many times two technicians will look at the same chart and paint two different scenarios or see different patterns. Both will be able to come up with logical support and resistance levels as well as key breaks to justify their position. While this can be frustrating, it should be pointed out that technical analysis is more like an art than a science, somewhat like economics. Is the cup half-empty or half-full? It is in the eye of the beholder. Too Late: Technical analysis has been criticized for being too late. By the time the trend is identified, a substantial portion of the move has already taken place. After such a large move, the reward to risk ratio is not great. Lateness is a particular criticism of Dow theory. Always Another Level: Even after a new trend has been identified, there is always another "important" level close at hand. Technicians have been accused of sitting on the fence and never taking an unqualified stance. Even if they are bullish, there is always some indicator or some level that will qualify their opinion. Trader's Remorse: Not all technical signals and patterns work. When you begin to study technical analysis, you will come across an array of patterns and indicators with rules to match. For instance: A sell signal is given when the neckline of a head and shoulders pattern is broken. Even though this is a rule, it is not steadfast and can be subject to other factors such as volume and momentum. In that same vein, what works for one particular stock may not work for another. A 50-day moving average may work great to identify support and resistance for IBM, but a 70-day moving average may work better for Yahoo. Even though many principles of technical analysis are universal, each security will have its own idiosyncrasies.

Conclusions

Technical analysts consider the market to be 80% psychological and 20% logical. Fundamental analysts consider the market to be 20% psychological and 80% logical. Psychological or logical may be open for debate, but there is no questioning the current http://www.stockcharts.com/education/What/Overview/techAnalysis2-print.html (3 of 4) [2/18/2003 3:28:25 AM]

StockCharts.com - Technical Analysis - Part 2

price of a security. After all, it is available for all to see and nobody doubts its legitimacy. The price set by the market reflects the sum knowledge of all participants, and we are not dealing with lightweights here. These participants have considered (discounted) everything under the sun and settled on a price to buy or sell. These are the forces of supply and demand at work. By examining price action to determine which force is prevailing, technical analysis focuses directly on the bottom line: What is the price? Where has it been? Where is it going? Even though there are some universal principles and rules that can be applied, it must be remembered that technical analysis is more an art form than a science. As an art form, it is subject to interpretation. However, it is also flexible in its approach and each investor should use only that which suits his or her style. Developing a style takes time, effort and dedication, but the rewards can be significant.

Written by Arthur Hill

Part 1 | Part 2

Send us your Feedback!

©2002 StockCharts.com All Rights Reserved Terms of Use

http://www.stockcharts.com/education/What/Overview/techAnalysis2-print.html (4 of 4) [2/18/2003 3:28:25 AM]

StockCharts.com - Fundamental Analysis - Part 1

Fundamental Analysis - Part 1

What is Fundamental Analysis?

Fundamental analysis is the examination of the underlying forces that affect the well being of the economy, industry groups, and companies. As with most analysis, the goal is to derive a forecast and profit from future price movements. At the company level, fundamental analysis may involve examination of financial data, management, business concept and competition. At the industry level, there might be an examination of supply and demand forces for the products offered. For the national economy, fundamental analysis might focus on economic data to assess the present and future growth of the economy. To forecast future stock prices, fundamental analysis combines economic, industry, and company analysis to derive a stock's current fair value and forecast future value. If fair value is not equal to the current stock price, fundamental analysts believe that the stock is either over or under valued and the market price will ultimately gravitate towards fair value. Fundamentalists do not heed the advice of the random walkers and believe that markets are weak-form efficient. By believing that prices do not accurately reflect all available information, fundamental analysts look to capitalize on perceived price discrepancies.

General Steps to Fundamental Evaluation

Even though there is no one clear-cut method, a breakdown is presented below in the order an investor might proceed. This method employs a top-down approach that starts with the overall economy and then works down from industry groups to specific companies. As part of the analysis process, it is important to remember that all information is relative. Industry groups are compared against other industry groups and companies against other companies. Usually, companies are compared with others in the same group. For example, a telecom operator (Verizon) would be compared to another telecom operator (SBC Corp), not to an oil company (ChevronTexaco).

Economic Forcast

First and foremost in a top-down approach would be an overall evaluation of the general http://www.stockcharts.com/education/What/Overview/fundAnalysis1-print.html (1 of 6) [2/18/2003 3:28:49 AM]

StockCharts.com - Fundamental Analysis - Part 1

economy. The economy is like the tide and the various industry groups and individual companies are like boats. When the economy expands, most industry groups and companies benefit and grow. When the economy declines, most sectors and companies usually suffer. Many economists link economic expansion and contraction to the level of interest rates. Interest rates are seen as a leading indicator for the stock market as well. Below is a chart of the S&P 500 and the yield on the 10-year note over the last 30 years. Although not exact, a correlation between stock prices and interest rates can be seen. Once a scenario for the overall economy has been developed, an investor can break down the economy into its various industry groups.

http://www.stockcharts.com/education/What/Overview/fundAnalysis1-print.html (2 of 6) [2/18/2003 3:28:49 AM]

StockCharts.com - Fundamental Analysis - Part 1

Group Selection

If the prognosis is for an expanding economy, then certain groups are likely to benefit more than others. An investor can narrow the field to those groups that are best suited to benefit from the current or future economic environment. If most companies are expected to benefit from an expansion, then risk in equities would be relatively low and an aggressive growth-oriented strategy might be advisable. A growth strategy might involve the purchase of technology, biotech, semiconductor and cyclical stocks. If the economy is forecast to contract, an investor may opt for a more conservative strategy and seek out stable income-oriented companies. A defensive strategy might involve the purchase of consumer staples, utilities and energy-related stocks. To assess a industry group's potential, an investor would what to consider the overall growth rate, market size, and importance to the economy. While the individual company is still important, its industry group is likely to exert just as much, or more, influence on the stock price. When stocks move, they usually move as groups; there are very few lone guns out there. Many times it is more important to be in the right industry than in the right stock! The chart below shows that relative performance of 5 sectors over a 7month time frame. As the chart illustrates, being in the right sector can make all the difference.

Narrow Within the Group

http://www.stockcharts.com/education/What/Overview/fundAnalysis1-print.html (3 of 6) [2/18/2003 3:28:49 AM]

StockCharts.com - Fundamental Analysis - Part 1

Once the industry group is chosen, an investor would need to narrow the list of companies before proceeding to a more detailed analysis. Investors are usually interested in finding the leaders and the innovators within a group. The first task is to identify the current business and competitive environment within a group as well as the future trends. How do the companies rank according to market share, product position and competitive advantage? Who is the current leader and how will changes within the sector affect the current balance of power? What are the barriers to entry? Success depends on an edge, be it marketing, technology, market share or innovation. A comparative analysis of the competition within a sector will help identify those companies with an edge, and those most likely to keep it.

Company Analysis

With a shortlist of companies, an investor might analyze the resources and capabilities within each company to identify those companies that are capable of creating and maintaining a competitive advantage. The analysis could focus on selecting companies with a sensible business plan, solid management and sound financials. Business plan The business plan, model or concept forms the bedrock upon which all else is built. If the plan, model or concepts stink, there is little hope for the business. For a new business, the questions may be: Does its business make sense? Is it feasible? Is there a market? Can a profit be made? For an established business, the questions may be: Is the company's direction clearly defined? Is the company a leader in the market? Can the company maintain leadership? Management In order to execute a business plan, a company requires top-quality management. Investors might look at management to assess their capabilities, strengths and weaknesses. Even the best-laid plans in the most dynamic industries can go to waste with bad management (AMD in semiconductors). Alternatively, even strong management can make for extraordinary success in a mature industry (Alcoa in aluminum). Some of the questions to ask might include: How talented is the management team? Do they have a track record? How long have they worked together? Can management deliver on its promises? If management is a problem, it is sometimes best to move on. Financial analysis The final step to this analysis process would be to take apart the financial statements and come up with a means of valuation. Below is a list of potential inputs into a financial analysis.

http://www.stockcharts.com/education/What/Overview/fundAnalysis1-print.html (4 of 6) [2/18/2003 3:28:49 AM]

StockCharts.com - Fundamental Analysis - Part 1

Accounts Payable Accounts Receivable Acid Ratio Amortization Assets - Current Assets - Fixed Book Value Brand Business Cycle Business Idea Business Model Business Plan Capital Expenses Cash Flow Cash on hand Current Ratio Customer Relationships Days Payable Days Receivable Debt Debt Structure Debt:Equity Ratio Depreciation Derivatives-Hedging Discounted Cash Flow Dividend Dividend Cover Earnings EBITDA Economic Growth Equity Equity Risk Premium Expenses

Good Will Gross Profit Margin Growth Industry Interest Cover International Investment Liabilities - Current Liabilities - Long-term Management Market Growth Market Share Net Profit Margin Pageview Growth Pageviews Patents Price/Book Value Price/Earnings PEG Price/Sales Product Product Placement Regulations R&D Revenues Sector Stock Options Strategy Subscriber Growth Subscribers Supplier Relationships Taxes Trademarks Weighted Average Cost of Capital

The list can seem quite long and intimidating. However, after a while, an investor will learn what works best and develop a set of preferred analysis techniques. There are many different valuation metrics and much depends on the industry and stage of the economic cycle. A complete financial model can be built to forecast future revenues, expenses and profits. (Click here for an explanation of the discounted cash flow (DCF) model.) Or, an investor can rely on the forecast of other analysts and apply various multiples to arrive at a valuation. Some of the more popular ratios are found by dividing the stock price by a key value driver.

http://www.stockcharts.com/education/What/Overview/fundAnalysis1-print.html (5 of 6) [2/18/2003 3:28:49 AM]

StockCharts.com - Fundamental Analysis - Part 1

Ratio

Company Type

Price/Book Value Price/Earnings Price/Earnings/Growth Price/Sales Price/Subscribers Price/Lines Price/Page views Price/Promises

Oil Retail Networking B2B ISP or cable company Telecom Web site Biotech

This methodology assumes that a company will sell at a specific multiple of its earnings, revenues or growth. An investor may rank companies based on these valuation ratios. Those at the high end may be considered overvalued, while those at the low end may constitute relatively good value. Putting it All Together

After all is said and done, an investor will be left with a handful of companies that stand out from the pack. Over the course of the analysis process, an understanding will develop of which companies stand out as potential leaders and innovators. In addition, other companies would be considered laggards and unpredictable. The final step of the fundamental analysis process is to synthesize all data, analysis and understanding into actual picks.

Written by Arthur Hill Part 1 | Part 2

Send us your Feedback!

©2002 StockCharts.com All Rights Reserved Terms of Use

http://www.stockcharts.com/education/What/Overview/fundAnalysis1-print.html (6 of 6) [2/18/2003 3:28:49 AM]

StockCharts.com - Fundamental Analysis - Part 2

Fundamental Analysis - Part 2

Strengths of Fundamental Analysis

Long-term Trends: Fundamental analysis is good for long-term investments based on long-term trends, very long-term. The ability to identify and predict long-term economic, demographic, technological or consumer trends can benefit patient investors who pick the right industry groups or companies. Value Spotting: Sound fundamental analysis will help identify companies that represent good value. Some of the most legendary investors think long-term and value. Graham and Dodd, Warren Buffett and John Neff are seen as the champions of value investing. Fundamental analysis can help uncover companies with valuable assets, a strong balance sheet, stable earnings and staying power. Business Acumen: One of the most obvious, but less tangible, rewards of fundamental analysis is the development of a thorough understanding of the business. After such painstaking research and analysis, an investor will be familiar with the key revenue and profit drivers behind a company. Earnings and earnings expectations can be potent drivers of equity prices. Even some technicians will agree to that. A good understanding can help investors avoid companies that are prone to shortfalls and identify those that continue to deliver. In addition to understanding the business, fundamental analysis allows investors to develop an understanding of the key value drivers and companies within an industry. A stock's price is heavily influenced by its industry group. By studying these groups, investors can better position themselves to identify opportunities that are highrisk (tech), low-risk (utilities), growth oriented (computer), value driven (oil), noncyclical (consumer staples), cyclical (transportation) or income oriented (high yield). Knowing Who's Who: Stocks move as a group. By understanding a company's business, investors can better position themselves to categorize stocks within their relevant industry group. Business can change rapidly and with it the revenue mix of a company. Some prominent old economy companies are moving into new economy businesses. Enron, a natural gas transmission company, is now making a market to buy and sell bandwidth. Some companies that are part of the new economy are really old economy companies in

http://www.stockcharts.com/education/What/Overview/fundAnalysis2-print.html (1 of 5) [2/18/2003 3:29:09 AM]

StockCharts.com - Fundamental Analysis - Part 2

disguise. This happened to many of the pure internet retailers, which were not really internet companies, but plain retailers. Knowing a company's business and being able to place it in a group can make a huge difference in relative valuations. Weaknesses of Fundamental Analysis

Time Constraints: Fundamental analysis may offer excellent insights, but it can be extraordinarily time consuming. Time consuming models often produce valuations that are contradictory to the current price prevailing on Wall Street. When this happens, the analyst basically claims that the whole street has got it wrong. This is not to say that there are not misunderstood companies out there, but it is quite brash to imply that the market price, and hence Wall Street, is wrong. Industry/Company Specific: Valuation techniques vary depending on the industry group and specifics of each company. For this reason, a different technique and model is required for different industries and different companies. This can get quite time consuming and limit the amount of research that can be performed. A subscription-based model may work great for an ISP, but is not likely to be the best model to value an oil company. Subjectivity: Fair value is based on assumptions. Any changes to growth or multiplier assumptions can greatly alter the ultimate valuation. Fundamental analysts are generally aware of this and use sensitivity analysis to present a base-case valuation, a best-case valuation and a worst-case valuation. However, even on a worst case, most models are almost always bullish, the only question is how much so. The table of new coverage initiatives for March 9, 2000 illustrates the bullish bias in sell-side research. (Source: Yahoo Finance)

Company

Sell-side Analyst

Rating

99 Cents Only Stores

Salomon Smth Brny

at Buy

American Dental Partners Inc Warburg Dillon Read

at Buy

Ann Taylor Stores Corp

Deutsche Bc Alex. Br at Mkt Perform

Ashford.com Inc

W.R. Hambrecht

at Mkt Outperform

Baldor Electric Co

George K. Baum

at Strong Buy

bebe stores, inc

Deutsche Bc Alex. Br at Mkt Perform

http://www.stockcharts.com/education/What/Overview/fundAnalysis2-print.html (2 of 5) [2/18/2003 3:29:09 AM]

StockCharts.com - Fundamental Analysis - Part 2

Charlotte Russe Holding Inc

Deutsche Bc Alex. Br at Buy

CompuCredit Corp

JP Morgan

at Buy

Coventry Health Care Inc

Goldman Sachs

at Market Perform

Delta & Pine Land Co

PaineWebber

at Buy

eSpeed Inc

Robertson Stephens

at Buy

FARGO ELECTRNCS

Raymond James

at Strong Buy

Fundtech Ltd

Robinson Humphrey

at Outperform

Globix Corp

Merrill Lynch

at NT Buy/LT Buy

Honeywell Inc

Warburg Dillon Read

at Strong Buy

Men's Wearhouse Inc

Deutsche Bc Alex. Br at Buy

Packaging Corp of America

Salomon Smth Brny

at Buy

Pactiv Corp

Salomon Smth Brny

at Outperform

PETS.COM INC

Warburg Dillon Read

at Buy

Radio One Inc

Mrgn Stnly Dn Wttr

at Strong Buy

Radiologix Inc

Warburg Dillon Read

at Buy

RealNetworks Inc

Wedbush Morgan

at Strong Buy

Talbots Inc

Deutsche Bc Alex. Br at Buy

Trigon Healthcare Inc

Goldman Sachs

at Market Outperform

UST Inc

FS Van Kasper

at Buy

WHITEHALL JEWL

CSFB

at Buy

World Access Inc

Mrgn Stnly Dn Wttr

at Strong Buy

Analyst Bias: The majority of the information that goes into the analysis comes from the company itself. Companies employ investor relations managers specifically to handle the analyst community and release information. As Mark Twain said, "there are lies, damn lies and statistics". When it comes to massaging the data or spinning the announcement, CFOs and investor relations managers are professionals. Only buy-side analysts tend to venture past the company statistics. Buy-side analysts work for mutual funds and money managers. They read the reports written by the sell-side analysts who work for the big brokers (CIBC, Merrill Lynch, Robertson Stephens, CS First Boston, Paine Weber, DLJ to name a few). These brokers are also involved in underwriting and investment banking for the companies. Even though there are Chinese walls in place to prevent a conflict of interest, the brokers have an ongoing relationship with the company under analysis. When reading these reports, it is important to take into http://www.stockcharts.com/education/What/Overview/fundAnalysis2-print.html (3 of 5) [2/18/2003 3:29:09 AM]

StockCharts.com - Fundamental Analysis - Part 2

consideration any biases a sell-side analyst may have. The buy-side analyst on the other hand is analyzing the company purely from an investment standpoint for a portfolio manager. If there is a relationship with the company, it is usually on different terms. In some cases this may be as a large shareholder. Definition of Fair Value: When market valuations extend beyond historical norms, there is pressure to adjust growth and multiplier assumptions to compensate. If Wall Street values a stock at 50 times earnings and the current assumption is 30 times, the analyst would be pressured to revise this assumption higher. There is an old Wall Street adage: the value of any asset (stock) is only what someone is willing to pay for it (current price). Just as stock prices fluctuate, so too will growth and multiplier assumptions. Are we to believe Wall Street and the stock price, or the analyst and the assumptions? It used to be that free cash flow or earnings were used with a multiplier to arrive at a fair value. In 1999, the S&P 500 typically sold for 28 times free cash flow. However, because so many companies were and are losing money, it has become popular to value a business as a multiple of its revenues. This would seem to be OK, except that the multiple was higher than the PE of many stocks! Some companies were considered bargains at 30 times revenues. Conclusions

Fundamental analysis can be valuable, but it should be approached with caution. If you are reading research written by a sell-side analyst, it is important to be familiar with the analyst behind the report. We all have personal biases and every analyst has some sort of bias. There is nothing wrong with this and the research can still be of great value. Learn what the ratings mean and the track record of an analyst before jumping off the deep end. Corporate statements and press releases offer good information, but should be read with a healthy degree of scepticism to separate the facts from the spin. Press releases don't happen by accident and are an important PR tool for companies. Investors should become skilled readers to weed out the important information and ignore the hype.

Written by Arthur Hill

Part 1 | Part 2

Send us your Feedback!

http://www.stockcharts.com/education/What/Overview/fundAnalysis2-print.html (4 of 5) [2/18/2003 3:29:09 AM]

StockCharts.com - Fundamental Analysis - Part 2

©2002 StockCharts.com All Rights Reserved Terms of Use

http://www.stockcharts.com/education/What/Overview/fundAnalysis2-print.html (5 of 5) [2/18/2003 3:29:09 AM]

Chart Analysis -- Chart School

SharpChart: Symbol Catalog

You are logged out Log in

You are here: Chart School > What is TA? > Chart Analysis

Search the Site:

Advanced Search

Chart Analysis

Chart School Technical Analysis Overview Chart Analysis Indicator Analysis Market Analysis Trading Strategies Analysis Tools SharpCharts PerfCharts Point & Figure Charts Stock Scans Market Carpet

What are Charts?Introduction to Chart PatternsTypes of Patterns-

A brief review of what chart patterns are, and how to recognize them. Reversal Patterns: Bump and Run ● Double Top ● Double Bottom ● Head and Shoulders Top ● Head and Shoulders Bottom ● Falling Wedge ● Rising Wedge ● Rounding Bottom ● Triple Top ● Triple Bottom ●

Additional Resources Bookstore Glossary Newsletter Archives Mailbag Articles Using StockCharts.com Recommended Sites

Join Now!

Introduction to Candlesticks-

Continuation Patterns: ● Cup with Handle ● Flag, Pennant ● Symmetric Triangle ● Ascending Triangle ● Descending Triangle ● Price Channel ● Rectangle ● Measured (Bear) Move ● Measured (Bull) Move

An overview of candlesticks, including history, formation, and key patterns. Part 1

Our Bookstore Books on: Our Favorites Technical Analysis Books by John Murphy P&F Charting General Investing

What charts are, how to pick timeframes, how charts are formed, and price scaling.

Part 2

Part 3

Part 4

Candlesticks and Support-

How candlestick chart patterns can mark support levels.

Candlesticks and Resistance-

How candlestick chart patterns can mark resistance levels.

Candlestick Bullish Reversals-

How to detect bullish reversals using candlestick patterns. Part 1

Part 2

http://www.stockcharts.com/education/What/ChartAnalysis/index.html (1 of 2) [2/18/2003 3:29:32 AM]

Chart Analysis -- Chart School

Candlestick Bearish Reversals-

How to detect bearish reversals using candlestick patterns. Part 1

TrendlinesSupport and Resistance-

Part 2

What trendlines are, scale settings, validation, angles, and more. What support and resistance are, where they are established, and methods used.

Financial Ad Trader

Join Now! | Newsletter | FAQ | Glossary | Terms of Use Home | Free Charts | Chart School | Members | Support Data provided by: Unless otherwise indicated, all data is delayed by 20 minutes ©1999-2003 StockCharts.com All Rights Reserved

http://www.stockcharts.com/education/What/ChartAnalysis/index.html (2 of 2) [2/18/2003 3:29:32 AM]

StockCharts.com - What are Charts?

What are Charts?

What are Charts?

A price chart is a sequence of prices plotted over a specific timeframe. In statistical terms, charts are referred to as time series plots.

(Current Chart for Minnesota Mining & Manufacturing) On the chart, the y-axis (vertical axis) represents the price scale and the x-axis (horizontal axis) represents the time scale. Prices are plotted from left to right across the x-axis with the most recent plot being the furthest right. The price plot for MMM extends from January 1, 1999 to March 13, 2000. Technicians, technical analysts and chartists use charts to analyze a wide array of securities and forecast future price movements. The word "securities" refers to any tradable financial instrument or quantifiable index such as stocks, bonds, commodities, futures or market indices. Any security with price data over a period of time can be used to form a chart for analysis. http://www.stockcharts.com/education/What/ChartAnalysis/whatAreCharts-print.html (1 of 11) [2/18/2003 3:30:37 AM]

StockCharts.com - What are Charts?

While technical analysts use charts almost exclusively, the use of charts is not limited to just technical analysis. Because charts provide an easy-to-read graphical representation of a security's price movement over a specific period of time, they can also be of great benefit to fundamental analysts. A graphical historical record makes it easy to spot the effect of key events on a security's price, its performance over a period of time and whether it's trading near its highs, near its lows, or in between.

How to Pick a Timeframe

The timeframe used for forming a chart depends on the compression of the data: intraday, daily, weekly, monthly, quarterly or annual data. The less compressed the data is, the more detail is displayed.

http://www.stockcharts.com/education/What/ChartAnalysis/whatAreCharts-print.html (2 of 11) [2/18/2003 3:30:37 AM]

StockCharts.com - What are Charts?

Daily data is made up of intraday data that has been compressed to show each day as a single data point, or period. Weekly data is made up of daily data that has been compressed to show each week as a single data point. The difference in detail can be seen with the daily and weekly chart comparison above. 100 data points (or periods) on the daily chart is equal to the last 5 months of the weekly chart, which is shown by the data marked in the rectangle. The more the data is compressed, the longer the timeframe possible for displaying the data. If the chart can display 100 data points, a weekly chart will hold 100 weeks (almost 2 years). A daily chart that displays 100 days would represent about 5 months. There are about 20 trading days in a month and about 252 trading days in a year. The choice of data compression and timeframe depends on the data available and your trading or investing style. ●

●

●

Traders usually concentrate on charts made up of daily and intraday data to forecast short-term price movements. The shorter the time frame and the less compressed the data is, the more detail that is available. While long on detail, short-term charts can be volatile and contain a lot of noise. Large sudden price movements, wide high-low ranges and price gaps can affect volatility, which can distort the overall picture. Investors usually focus on weekly and monthly charts to spot long-term trends and forecast long-term price movements. Because long-term charts (typically 1-4 years) cover a longer timeframe with compressed data, price movements do not appear as extreme and there is often less noise. Others might use a combination of long-term and short-term charts. Long-term charts are good for analyzing the large picture to get a broad perspective of the historical price action. Once the general picture is analyzed, a daily chart can be used to zoom in on the last few months.

How are Charts Formed?

We will be explaining the construction of line, bar, candlestick and point & figure charts. Although there are other methods available, these are 4 of the most popular methods for displaying price data. Line Chart: http://www.stockcharts.com/education/What/ChartAnalysis/whatAreCharts-print.html (3 of 11) [2/18/2003 3:30:37 AM]

StockCharts.com - What are Charts?

The line chart is one of the simplest charts. It is formed by plotting one price point, usually the close, of a security over a period of time. Connecting the dots, or price points, over a period of time, creates the line.

(Current Chart for Sun Microsystems) Some investors and traders consider the closing level to be more important than the open, high or low. By paying attention to only the close, intraday swings can be ignored. Line charts are also used when open, high and low data points are not available. Sometimes only closing data are available for certain indices, thinly traded stocks and intraday prices. Bar Chart: Perhaps the most popular charting method is the bar chart. The high, low and close are required to form the price plot for each period of a bar chart. The high and low are represented by the top and bottom of the vertical bar and the close is the short horizontal line crossing the vertical bar. On a daily chart, each bar represents the high, low and close for a particular day. Weekly charts would have a bar for each week based on Friday's close and the high and low for that week.

http://www.stockcharts.com/education/What/ChartAnalysis/whatAreCharts-print.html (4 of 11) [2/18/2003 3:30:37 AM]

StockCharts.com - What are Charts?

Bar charts can also be displayed using the open, high, low and close. The only difference is the addition of the open price, which is displayed as a short horizontal line extending to the left of the bar. Whether or not a bar chart includes the open depends on the data available.

http://www.stockcharts.com/education/What/ChartAnalysis/whatAreCharts-print.html (5 of 11) [2/18/2003 3:30:37 AM]

StockCharts.com - What are Charts?

Bar charts can be effective for displaying a large amount of data. Using candlesticks, 200 data points can take up a lot of room and look cluttered. Line charts show less clutter, but do not offer as much detail (no high-low range). The individual bars that make up the bar chart are relatively skinny, which allows users the ability to fit more bars before the chart gets cluttered. If you are not interested in the opening price, bar charts are an ideal method for analyzing the close relative to the high and low. In addition, bar charts that include the open will tend to get cluttered quicker. If you are interested in the opening price, candlestick charts probably offer a better alternative. Candlestick Chart: Originating in Japan over 300 years ago, candlestick charts have become quite popular in recent years. For a candlestick chart, the open, high, low and close are all required. A daily candlestick is based on the open price, the intraday high and low, and the close. A weekly candlestick is based on Monday's open, the weekly high-low range and Friday's close.

http://www.stockcharts.com/education/What/ChartAnalysis/whatAreCharts-print.html (6 of 11) [2/18/2003 3:30:37 AM]

StockCharts.com - What are Charts?

Many traders and investors believe that candlestick charts are easy to read, especially the relationship between the open and the close. White (clear) candlesticks form when the close is higher than the open and black (solid) candlesticks form when the close is lower than the open. The white and black portion formed from the open and close is called the body (white body or black body). The lines above and below are called shadows and represent the high and low. Point & Figure Chart: The charting methods shown above all plot one data point for each period of time. No matter how much price movement, each day or week represented is one point, bar or candlestick along the time scale. Even if the price is unchanged from day to day or week to week, a dot, bar or candlestick is plotted to mark the price action. Contrary to this methodology, Point & Figure Charts are based solely on price movement and do not take time into consideration. There is an x-axis but it does not extend evenly across the chart.

The beauty of Point & Figure Charts is their simplicity. Little or no price movement is deemed irrelevant and therefore not duplicated on the chart. Only price movements that exceed specified levels are recorded. This focus on price movement makes it easier to

http://www.stockcharts.com/education/What/ChartAnalysis/whatAreCharts-print.html (7 of 11) [2/18/2003 3:30:37 AM]

StockCharts.com - What are Charts?

identify support and resistance levels, bullish breakouts and bearish breakdowns. This article has a more detailed explanation of Point & Figure Charts.

Price Scaling

There are two methods for displaying the price scale along the y-axis: arithmetic and logarithmic. An arithmetic scale displays 10 points (or dollars) as the same vertical distance no matter what the price level. Each unit of measure is the same throughout the entire scale. If a stock advances from 10 to 80 over a 6-month period, the move from 10 to 20 will appear to be the same distance as the move from 70 to 80. Even though this move is the same in absolute terms, it is not the same in percentage terms. A logarithmic scale measures price movements in percentage terms. An advance from 10 to 20 would represent an increase of 100%. An advance from 20 to 40 would also be 100%, as would an advance from 40 to 80. All three of these advances would appear as the same vertical distance on a logarithmic scale. Most charting programs refer to the logarithmic scale as a semi-log scale, because the time axis is still displayed arithmetically.

http://www.stockcharts.com/education/What/ChartAnalysis/whatAreCharts-print.html (8 of 11) [2/18/2003 3:30:37 AM]

StockCharts.com - What are Charts?

(Current Chart for Verisign) The chart above uses the 4th-Quarter performance of Verisign to illustrate the difference in scaling. On the semi-log scale, the distance between 50 and 100 is the same as the distance between 100 and 200. However, on the arithmetic scale, the distance between 100 and 200 is significantly greater than the distance between 50 and 100.

http://www.stockcharts.com/education/What/ChartAnalysis/whatAreCharts-print.html (9 of 11) [2/18/2003 3:30:37 AM]

StockCharts.com - What are Charts?

Key points on the benefits of arithmetic and semi-log scales: ●

●

●

● ●

●

Arithmetic scales are useful when the price range is confined within a relatively tight range. Arithmetic scales can be useful for short-term charts and trading. Price movements (particularly for stocks) are shown in absolute dollar terms and reflect movements dollar for dollar. Semi-log scales are useful when the price has moved significantly, be it over a short or extended timeframe Trendlines tend to match lows better on semi-log scales. Semi-log scales can be useful for long-term charts to gauge the percentage movements over a long period of time. Large movements are put into perspective. Stocks and many other securities are judged in relative terms through the use of ratios such as PE, Price/Revenues and Price/Book. With this in mind, it also makes sense to analyze price movements in percentage terms.

Conclusions

Even though many different charting techniques are available, one method is not necessarily better than the other. The data may be the same, but each method will provide its own unique interpretation, with its own benefits and drawbacks. A breakout on the Point & Figure Chart may not occur in unison with a breakout in a candlestick chart. Signals that are available on candlestick charts may not appear on bar charts. How the security's price is displayed, be it a bar chart or candlestick chart, with an arithmetic scale or semi-log scale, is not the most important aspect. After all, the data is the same and price action is price action. When all is said and done, it is the analysis of the price action that separates successful technicians from not-so-successful technicians. The choice of which charting method to use will depend on personal preferences and trading or investing styles. Once you have chosen a particular charting methodology, it is probably best to stick with it and learn how best to read the signals. Switching back and forth may cause confusion and undermine the focus of your analysis. Faulty analysis is rarely caused by the chart. Before blaming your charting method for missing a signal, first look at your analysis. The keys to successful chart analysis are dedication, focus and consistency. ●

●

●

Dedication: Learn the basics of chart analysis, apply your knowledge on a regular basis and continue your development. Focus: Limit the number of charts, indicators and methods you use. Learn how to use these and learn how to use them well. Consistency: Maintain your charts on a regular basis and study them often (daily if possible).

http://www.stockcharts.com/education/What/ChartAnalysis/whatAreCharts-print.html (10 of 11) [2/18/2003 3:30:37 AM]

StockCharts.com - What are Charts?

Written by Arthur Hill Send us your Feedback!

©2002 StockCharts.com All Rights Reserved Terms of Use

http://www.stockcharts.com/education/What/ChartAnalysis/whatAreCharts-print.html (11 of 11) [2/18/2003 3:30:37 AM]

StockCharts.com - Trendlines

Trendlines Technical analysis is built on the assumption that prices trend. Trendlines are an important tool in technical analysis for both trend identification and confirmation. A trendline is a straight line that connects two or more price points and then extends into the future to act as a line of support or resistance. Many of the principles applicable to support and resistance levels can be applied to trendlines as well. Definition

Up Trendline An up trendline has a positive slope and is formed by connecting two of more low points. The second low must be higher than the first for the line to have a positive slope. Up trendlines act as support and indicate that net-demand (demand less supply) is increasing even as the price rises. A rising price combined with increasing demand is very bullish and shows a strong determination on the part of the buyers. As long as prices remain above the trendline, the uptrend is considered solid and intact. A break below the up trendline indicates that net-demand has weakened and a change in trend

http://www.stockcharts.com/education/What/ChartAnalysis/trendlines-print.html (1 of 10) [2/18/2003 3:31:10 AM]

StockCharts.com - Trendlines

could be imminent.

Down Trendline A down trendline has a negative slope and is formed by connecting two or more high points. The second high must be lower than the first for the line to have a negative slope. Down trendlines act as resistance and indicate that net-supply (supply less demand) is increasing even as the price declines. A declining price combined with increasing supply is very bearish and shows the strong resolve of the sellers. As long as prices remain below the down trendline, the downtrend is considered solid and intact. A break above the down trendline indicates that net-supply is decreasing and a change of trend could be imminent. For a detailed explanation of trend changes, which are different than just trendline breaks, please see our series on the Dow Theory. Scale Settings

High points and low points appear to line up better for trendlines when prices are displayed using a semi-log scale. This is especially true when long-term trendlines are being drawn or there has been a large change in price. Most charting programs allow users to set the scale as arithmetic or semi-log. An arithmetic scale displays incremental values (5,10,15,20,25,30) evenly as they move up the y-axis. A $10 movement in price will look the same from $10 to $20 or from $100 to $110. A semi-log scale displays incremental values in percentage terms as they move up the y-axis. A move from $10 http://www.stockcharts.com/education/What/ChartAnalysis/trendlines-print.html (2 of 10) [2/18/2003 3:31:10 AM]

StockCharts.com - Trendlines

to $20 is a 100% gain and would appear to be a much larger than a move from $100 to $110, which is only a 10% gain.

In the case of EMC, there was a large price change over a long period of time. While there were not any false breaks below the up trendline on the arithmetic scale, the rate of ascent appears smoother on the semi-log scale. EMC doubled three times in less than two years. On the semi-log scale, the trendline fits all the way up. On the arithmetic scale, three different trendlines were required to keep pace with the advance.

http://www.stockcharts.com/education/What/ChartAnalysis/trendlines-print.html (3 of 10) [2/18/2003 3:31:10 AM]

StockCharts.com - Trendlines

In the case of BD, there were two false breaks above the down trendline as the stock declined during 1999 and 2000. These false break outs could have led to premature buying as the stock continued to decline after each one. The stock lost 50% of its value three times over a two year period. The semi-log scale reflects the percentage loss evenly and the down trendline was never broken. Validation

http://www.stockcharts.com/education/What/ChartAnalysis/trendlines-print.html (4 of 10) [2/18/2003 3:31:10 AM]

StockCharts.com - Trendlines

It takes two or more points to draw a trendline. The more points used to draw the trendline, the more validity attached to the support or resistance level represented by the trendline. It can sometimes be difficult to find more than 2 points from which to construct a trendline. Even though trendlines are an important aspect of technical analysis, it is not always possible to draw trendlines on every price chart. Sometimes the lows or highs just don't match up and it is best not to force the issue. The general rule in technical analysis is that it takes two points to draw a trendline and the third point confirms the validity.

The chart of MSFT shows an up trendline that has been touched 4 times. After the third touch in Nov-99, the trendline was considered a valid line of support. Now that the stock has bounced off of this level a fourth time, the soundness of the support level is enhanced even more. As long as the stock remains above the trendline (support), the trend will remain in control of the bulls. A break below would signal that net-supply was increasing and a change in trend could be imminent. Spacing of Points

The lows used to form an up trendline and the highs used to form a down trendline should not be too far apart, or too close together. The most suitable distance apart will depend on the timeframe, the degree of price movement and personal preferences. If the lows (highs) are too close together, the validity of the reaction low (high) may be in question. If the lows are too far apart, the relationship between the two points could be suspect. An ideal trendline is made up of relatively evenly spaced lows (or highs). The http://www.stockcharts.com/education/What/ChartAnalysis/trendlines-print.html (5 of 10) [2/18/2003 3:31:10 AM]

StockCharts.com - Trendlines

trendline in the MSFT example represents well-spaced low points.

On the WMT example, the second high point appears to be too close to the first high point for a valid trendline. However, it would be feasible to draw a trendline beginning from point 2 and extending down to the February reaction high. Angles

As the steepness of a trendline increases, the validity of the support or resistance level decreases. A steep trendline results from a sharp advance (or decline) over a brief period of time. The angle of a trendline created from such sharp moves is unlikely to offer a meaningful support or resistance level. Even if the trendline is formed with three seemingly valid points, attempting to play a trendline break or use the support and resistance level that has been established will often prove difficult.

http://www.stockcharts.com/education/What/ChartAnalysis/trendlines-print.html (6 of 10) [2/18/2003 3:31:10 AM]

StockCharts.com - Trendlines

The trendline for YHOO was touched four times over a 5-month period. The spacing between the points appears OK, but the steepness of the trendline is unsustainable and the price is more likely than not to drop below the trendline. However, trying to time this drop or make a play after the trendline is broken is a difficult task. The amount of data displayed and chart size can also affect the angle of a trendline. Short and wide charts are less likely to have steep trendlines than long and narrow charts. Keep this in mind when assessing the validity and sustainability of a trendline. Internal Trendlines

Sometimes there appears to be the possibility for drawing a trendline, but the exact

http://www.stockcharts.com/education/What/ChartAnalysis/trendlines-print.html (7 of 10) [2/18/2003 3:31:10 AM]

StockCharts.com - Trendlines

points do not match up quite right. The highs or lows may be out of whack, the angle may be too steep or the points may seem too close together. If one or two points could be ignored, then a fitted trendline could be formed. With the volatility present in the market, prices can over-react and produced spikes that may distort the highs and lows. One method for dealing with over-reactions is to draw internal trendlines. Even though an internal trendline ignores price spikes, the ignoring should be within reason.

The long-term trendline for the S&P 500 extends up from the end of 1994 and passes through low points in Jul-96, Sept-98 and Oct-98. These lows were formed with selling climaxes and represented extreme price movements that protrude beneath the trendline. By drawing the trendline through the lows, the line appears to be at a reasonable angle and the other lows match up extremely well.

http://www.stockcharts.com/education/What/ChartAnalysis/trendlines-print.html (8 of 10) [2/18/2003 3:31:10 AM]

StockCharts.com - Trendlines

Sometimes there is a price cluster with a high or low spike sticking out. A price cluster is an area where prices are grouped within a tight range over a period of time. The price cluster can be used to draw the trendline and the spike can be ignored. The KO chart shows an internal trendline that is formed by ignoring price spikes and using the price clusters instead. In October and November 1998, KO formed a peak with the November peak just higher than the October peak (1). If the November peak had been used to draw a trendline, then the slope would have been more negative and there would have appeared to be a breakout in Dec-98 (gray line). However, this would have only been a two point trendline because the May-June highs are too close together (black arrows). Once the Dec-99 peak formed (green arrow), it would have been possible to draw an internal trendline based on the price clusters around the Oct/Nov-98 and the Dec-99 peaks (blue line). This trendline is based on three solid touches and accurately forecast resistance in Jan-00 (blue arrow). Conclusion

Trendlines can offer great insight, but if not used properly can also result in false signals. Other items such as horizontal support and resistance levels or peak and trough analysis should be employed to validate trendline breaks. While trendlines have become a very popular aspect of technical analysis, they are merely one tool for establishing, analyzing and confirming the trend. Trendlines should not be the final arbiter, but serve as a warning that a change in trend may be imminent. By using trendline breaks for warnings, investors and traders can pay closer attention to other confirming signals for a potential change in trend. http://www.stockcharts.com/education/What/ChartAnalysis/trendlines-print.html (9 of 10) [2/18/2003 3:31:10 AM]

StockCharts.com - Trendlines

The up trendline for VRSN was touched 4 times and seemed to be a valid support level. Even though the trendline was broken in Jan-00, the previous reaction low held and did not confirm the trendline break. In addition, the stock recorded a new higher high prior to the trendline break.

Written by Arthur Hill Send us your Feedback!

©2002 StockCharts.com All Rights Reserved Terms of Use

http://www.stockcharts.com/education/What/ChartAnalysis/trendlines-print.html (10 of 10) [2/18/2003 3:31:10 AM]

StockCharts.com - Support and Resistance

Support and Resistance Support and resistance represent key junctures where the forces of supply and demand meet. In the financial markets, prices are driven by excessive supply (down) and demand (up). Supply is synonymous with bearish, bears and selling. Demand is synonymous with bullish, bulls and buying. These terms are used interchangeably throughout this and other articles. As demand increases, prices advance and as supply increases, prices decline. When supply and demand are equal, prices move sideways as bulls and bears slug it out for control. What is Support?

Support is the price level at which demand is thought to be strong enough to prevent the price from declining further. The logic dictates that as the price declines towards support and gets cheaper, buyers become more inclined to buy and sellers become less inclined to sell. By the time the price reaches the support level, it is believed that demand will overcome supply and prevent the price from falling below support.

http://www.stockcharts.com/education/What/ChartAnalysis/supportResistance-print.html (1 of 10) [2/18/2003 3:31:38 AM]

StockCharts.com - Support and Resistance

Support does not always hold and a break below support signals that the bears have won out over the bulls. A decline below support indicates a new willingness to sell and/or a lack of incentive to buy. Support breaks and new lows signal that sellers have reduced their expectations and are willing sell at even lower prices. In addition, buyers could not be coerced into buying until prices declined below support or below the previous low. Once support is broken, another support level will have to be established at a lower level.

Where is Support Established?

Support levels are usually below the current price, but it is not uncommon for a security to trade at or near support. Technical analysis is not an exact science and it is sometimes difficult to set exact support levels. In addition, price movements can be volatile and dip below support briefly. Sometimes it does not seem logical to consider a support level broken if the price closes 1/8 below the established support level. For this reason, some traders and investors establish support zones.

What is Resistance?

Resistance is the price level at which selling is thought to be strong enough to prevent the price from rising further. The logic dictates that as the price advances towards resistance, sellers become more inclined to sell and buyers become less inclined to buy. By the time the price reaches the resistance level, it is believed that supply will overcome demand and prevent the price from rising above resistance.

http://www.stockcharts.com/education/What/ChartAnalysis/supportResistance-print.html (2 of 10) [2/18/2003 3:31:38 AM]

StockCharts.com - Support and Resistance

Resistance does not always hold and a break above resistance signals that the bulls have won out over the bears. A break above resistance shows a new willingness to buy and/or a lack of incentive to sell. Resistance breaks and new highs indicate buyers have increased their expectations and are willing to buy at even higher prices. In addition, sellers could not be coerced into selling until prices rose above resistance or above the previous high. Once resistance is broken, another resistance level will have to be established at a higher level.

Where is Resistance Established?

Resistance levels are usually above the current price, but it is not uncommon for a security to trade at or near resistance. In addition, price movements can be volatile and rise above resistance briefly. Sometimes it does not seem logical to consider a resistance level broken if the price closes 1/8 above the established resistance level. For this reason, some traders and investors establish resistance zones.

Methods to Establish Support and Resistance?

Support and resistance are like mirror images and have many common characteristics. Highs and Lows: http://www.stockcharts.com/education/What/ChartAnalysis/supportResistance-print.html (3 of 10) [2/18/2003 3:31:38 AM]

StockCharts.com - Support and Resistance

Support can be established with the previous reaction lows. Resistance can be established by using the previous reaction highs.

The chart for HAL shows a large trading range between Dec-99 and Mar-00. Support was established with the October low around 33. In December, the stock returned to support in the mid-thirties and formed a low around 34. Finally, in February the stock again returned to the support scene and formed a low around 33 1/2. After each bounce off support, the stock traded all the way up to resistance. Resistance was first established by the September support break at 44. After a support level is broken, it can turn into a resistance level. From the October lows, the stock advanced to the new support-turned-resistance level around 44. When the stock failed to advance past 44, the resistance level was confirmed. The stock subsequently traded up to 44 two more times after that and failed to surpass resistance both times. Support = Resistance Another principle of technical analysis stipulates that support can turn into resistance and visa versa. Once the price breaks below a support level, the broken support level can turn into resistance. The break of support signals that the forces of supply have overcome the forces of demand. Therefore, if the price returns to this level, there is likely to be an increase in supply, and hence resistance. The other turn of the coin is resistance turning into support. As the price advances above resistance, it signals changes in supply and demand. The breakout above resistance proves that the forces of demand have overwhelmed the forces of supply. If http://www.stockcharts.com/education/What/ChartAnalysis/supportResistance-print.html (4 of 10) [2/18/2003 3:31:38 AM]

StockCharts.com - Support and Resistance

the price returns to this level, there is likely to be an increase in demand and support will be found.

In the CPQ example, the stock broke resistance at 25 Nov-99 and traded just above this resistance level for over a month. The ability to remain above resistance established 25 as a new support level. The stock subsequently rose to 34, but then fell back to test support at 25. After the second test of support at 25, this level is well established.

http://www.stockcharts.com/education/What/ChartAnalysis/supportResistance-print.html (5 of 10) [2/18/2003 3:31:38 AM]

StockCharts.com - Support and Resistance

From the PSFT example, we can see that support can turn into resistance and then back into support. PSFT found support at 18 from Oct-98 to Jan-99 (green oval), but broke below support in Mar-99 as the bears overpowered the bulls. When the stock rebounded (red oval), there was still overhead supply at 18 and resistance was met from Jun-99 to Oct-99. Where does this overhead supply come from? Demand was obviously increasing around 18 from Oct-98 to Mar-99 (green oval). Therefore, there were a lot of buyers in the stock around 18. When the price declined past 18 and to around 14, many of these buyers were probably still holding the stock. This left a supply overhang (commonly known as resistance) around 18. When the stock rebounded to 18, many of the greenoval-buyers (who bought around 18) probably took the opportunity to sell. When this supply was exhausted, the demand was able to overpower supply and advance above resistance at 18. Trading Range Trading ranges can play an important role in determining support and resistance as turning points or as continuation patterns. A trading range is a period of time when prices move within a relatively tight range. This signals that the forces of supply and demand are evenly balanced. When the price breaks out of the trading range, above or below, it signals that a winner has emerged. A break above is a victory for the bulls (demand) and a break below is a victory for the bears (supply).

http://www.stockcharts.com/education/What/ChartAnalysis/supportResistance-print.html (6 of 10) [2/18/2003 3:31:38 AM]

StockCharts.com - Support and Resistance

After an extended advance from 27 to 64, WCOM entered into a trading range between 55 and 63 for about 5 months. There was a false breakout in mid-June when the stock briefly poked its head above 62 (red oval). This did not last long and a gap down a few days later nullified the breakout (gray arrow). The stock then proceeded to break support at 55 in Aug-99 and trade as low as 50. Here is another example of support turned resistance as the stock bounced off 55 two more times before heading lower. While this does not always happen, a return to the new resistance level offers a second chance for longs to get out and shorts to enter the fray.

http://www.stockcharts.com/education/What/ChartAnalysis/supportResistance-print.html (7 of 10) [2/18/2003 3:31:38 AM]

StockCharts.com - Support and Resistance

In Nov/Dec-99, the LU formed a trading range that resembled a head and shoulders pattern (red arrow). When the stock broke support at 72 1/2, there was little or no time to exit. Even though the there is a long black candlestick indicating an open at 71 13/16, the stock fell so fast that it was impossible to exit above 55. In hindsight, the support line could have been drawn as an upward sloping neckline (blue line) and the support break would have come at 73 1/2. This is only 1 point higher and a trader would have had to take action immediately to avoid a sharp fall. However, the lows match up rather nicely on the neckline and it is something to consider when drawing support lines. After LU declined, a trading range was established between 51 and 58 for almost two months (green oval). The resistance level of the trading range was well marked by three reaction peaks at 58. The support level was not as clearly marked, but appeared to be between 51 and 50. Some buying interest began to become evident around 53, in mid to late February . Notice the array of candlesticks with long lower shadows, or hammers as they are known. The stock then proceeded to form two up gaps on 24-Feb and 25-Feb, and close above resistance at 58. This was a clear indication of demand winning out over supply. There were still two more opportunities (days) to get in on the action. On the third day after the breakout, the stock gapped up and moved above 70. Support and Resistance Zones Because technical analysis is not an exact science, it is sometimes useful to create support and resistance zones. This is contrary to the strategy mapped out for LU, but it is sometimes the case. Each security has its own characteristics and the analysis should reflect the intricacies of the security. Sometimes exact support and resistance levels are best and sometimes zones work better. Generally, the tighter the range, the more exact http://www.stockcharts.com/education/What/ChartAnalysis/supportResistance-print.html (8 of 10) [2/18/2003 3:31:38 AM]

StockCharts.com - Support and Resistance

the level. If the trading range spans less than 2 months and the price range is relatively tight, then more exact support and resistance levels are probably best suited. If a trading range spans many months and the price range is relatively large, then it is probably best to use support and resistance zones. These are only meant as general guidelines and each trading range should be judged on its own merits.

Returning to the analysis of HAL, we can see that the November high of the trading range (33 to 44) extended more than 20% past the low, making the range quite large relative to the price. Because the September support break forms our first resistance level, we are ready to set up a resistance zone after the November high is formed, probably around early December. At this point though, we are still unsure if a large trading range will develop. The subsequent low in December, which was just higher than the October low, offers evidence that a trading range is forming and we are ready to set the support zone. As long as the stock trades within the boundaries set by the support and resistance zone, we will consider the trading range to be valid. Support may be looked upon as an opportunity to buy and resistance as an opportunity to sell.

Conclusion

Identification of key support and resistance levels is an essential ingredient to successful technical analysis. Even though it is sometimes difficult to establish exact support and resistance levels, being aware of their existence and location can greatly enhance analysis and forecasting abilities. If a security is approaching an important http://www.stockcharts.com/education/What/ChartAnalysis/supportResistance-print.html (9 of 10) [2/18/2003 3:31:38 AM]

StockCharts.com - Support and Resistance

support level, it can serve as an alert to be extra vigilant in looking for signs of increased buying pressure and a potential reversal. If a security is approaching a resistance level, it can act as an alert to look for signs of increased selling pressure and potential reversal. If a support or resistance level is broken, it signals that the relationship between supply and demand has changed. A resistance breakout signals that demand (bulls) has gained the upper hand and a support break signals that supply (bears) has won the battle.

Written by Arthur Hill Send us your Feedback!

©2002 StockCharts.com All Rights Reserved Terms of Use

http://www.stockcharts.com/education/What/ChartAnalysis/supportResistance-print.html (10 of 10) [2/18/2003 3:31:38 AM]

StockCharts.com - Introduction to Chart Patterns

Introduction to Chart Patterns There are hundreds of thousands of market participants buying and selling securities for a wide variety of reasons: hope of gain, fear of loss, tax consequences, short-covering, hedging, stop-loss triggers, price target triggers, fundamental analysis, technical analysis, broker recommendations and a few dozen more. Trying to figure out why participants are buying and selling can be a daunting process. Chart patterns put all buying and selling into perspective by consolidating the forces of supply and demand into a concise picture. As a complete pictorial record of all trading, chart patterns provide a framework to analyze the battle raging between bulls and bears. More importantly, chart patterns and technical analysis can help determine who is winning the battle, allowing traders and investors to position themselves accordingly. Chart pattern analysis can be used to make short-term or long-term forecasts. The data can be intraday, daily, weekly or monthly and the patterns can be as short as one day or as long as many years. Gaps and outside reversals may form in one trading session, while broadening tops and dormant bottoms may require many months to form.

http://www.stockcharts.com/education/What/ChartAnalysis/chartPatterns-print.html (1 of 6) [2/18/2003 5:07:38 AM]

StockCharts.com - Introduction to Chart Patterns

(Current Chart for Amazon)

http://www.stockcharts.com/education/What/ChartAnalysis/chartPatterns-print.html (2 of 6) [2/18/2003 5:07:38 AM]

StockCharts.com - Introduction to Chart Patterns

(Current Chart for Ciena)

An Oldie but Goodie Much of our understanding of chart patterns can be attributed to the work of Richard Schabacker. His 1932 classic, Technical Analysis and Stock Market Profits, laid the foundations for modern pattern analysis. In Technical Analysis of Stock Trends (1948), Edwards and Magee credit Schabacker for most of the concepts put forth in the first part of their book. We would also like to acknowledge Messrs. Schabacker, Edwards and Magee, and John Murphy as the driving forces behind these articles and our understanding of chart patterns. Pattern analysis may seem straightforward, but it is by no means an easy task. Schabacker states: The science of chart reading, however, is not as easy as the mere memorizing of certain patterns and pictures and recalling what they generally forecast. Any general stock chart is a combination of countless different patterns and its accurate analysis depends upon constant study, long experience and knowledge of all the fine points, both technical and fundamental, and, above all, the ability to weigh opposing indications against each other, to appraise the entire picture in the light of its most minute and composite details as well as in the recognition of any certain and memorized formula.

http://www.stockcharts.com/education/What/ChartAnalysis/chartPatterns-print.html (3 of 6) [2/18/2003 5:07:38 AM]

StockCharts.com - Introduction to Chart Patterns

Even though Schabacker refers to "the science of chart reading", technical analysis can at times be less science and more art. In addition, pattern recognition can be open to interpretation, which can be subject to personal biases. To defend against biases and confirm pattern interpretations, other aspects of technical analysis should be employed to verify or refute the conclusions drawn. While many patterns may seem similar in nature, no two patterns are exactly alike. False breakouts, bogus reads and exceptions to the rule are all part of the ongoing education. Careful and constant study are required for successful chart analysis. On the AMZN chart above, the stock broke resistance from a head and shoulders reversal. While the trend is now bearish, analysis must continue to confirm the bearish trend.

(Current Chart for Novellus) Some analysts might have labeled the NVLS chart as a head and shoulders patterns with neckline support around 17.50. Whether or not this is robust remains open to debate. Even though the stock broke neckline support at 17.50, it repeatedly moved back above its support break. This refusal might have been taken as a sign of strength and justify a reassessment of the pattern. Two Dominant Groups Two basic tenets of technical analysis are that prices trend and that history repeats itself. An uptrend indicates that the forces of demand (bulls) are in control and a downtrend that the forces of supply (bears) are in control. However, prices do not trend forever and as the balance of power shifts, a chart pattern begins to emerge. Certain patterns, such as a parallel channel, denote a strong trend. However, the vast majority http://www.stockcharts.com/education/What/ChartAnalysis/chartPatterns-print.html (4 of 6) [2/18/2003 5:07:38 AM]

StockCharts.com - Introduction to Chart Patterns

of chart patterns fall into two main groups: reversal and continuation. Reversal patterns indicate a change of trend and can be broken down into top and bottom formations. Continuation patterns indicate a pause in trend and indicate that the previous direction will resume after a period of time.

(Current Chart for Microsoft)

Just because a pattern forms after a significant advance or decline does not mean it is a reversal pattern. Many patterns, such as a rectangle, can be classified as either reversal or continuation. Much depends on the previous price action, volume and other indicators as the pattern evolves. This is where the science of technical analysis becomes the art of technical analysis. For detailed explanations of specific chart patterns, see the Chart Analysis page in the Chart School.

Written by Arthur Hill Send us your Feedback!

http://www.stockcharts.com/education/What/ChartAnalysis/chartPatterns-print.html (5 of 6) [2/18/2003 5:07:38 AM]

StockCharts.com - Introduction to Chart Patterns

©2002 StockCharts.com All Rights Reserved Terms of Use

http://www.stockcharts.com/education/What/ChartAnalysis/chartPatterns-print.html (6 of 6) [2/18/2003 5:07:38 AM]

StockCharts.com - Introduction to Candlesticks

Introduction to Candlesticks History The Japanese began using technical analysis to trade rice in the 17th century. While this early version of technical analysis may have been different from the US version initiated by Charles Dow around 1900, many of the guiding principles were very similar. ●

● ●

● ●

The "what" (price action) is more important than the "why" (news, earnings, and so on). All known information is reflected in the price. Buyers and sellers move markets based on expectations and emotions (fear and greed). Markets fluctuate. The actual price may not reflect the underlying value.

According to Steve Nison, candlestick charting came later and probably began sometime after 1850. Much of the credit for candlestick development and charting goes to Homma, a legendary rice trader from Sakata. Even though it is not exactly clear "who" created candlesticks, Nison notes that they likely resulted from a collective effort developed over many years of trading.

http://www.stockcharts.com/education/What/ChartAnalysis/candlesticks-print.html (1 of 8) [2/18/2003 5:08:54 AM]

StockCharts.com - Introduction to Candlesticks

Formation Candlesticks are formed using the open, high, low and close. Without opening prices, candlestick charts are impossible to draw. If the close is above the open, then a hollow candlestick (usually displayed as white) is drawn. If the close is below the open, then a filled candlestick (usually displayed as black) is drawn. The hollow or filled portion of the candlestick is called the body (also referred to as the "real body"). The long thin lines above and below the body represent the high/low range and are called shadows (also referred to as wicks and tails). The high is marked by the top of the upper shadow and the low by the bottom of the lower shadow.

http://www.stockcharts.com/education/What/ChartAnalysis/candlesticks-print.html (2 of 8) [2/18/2003 5:08:55 AM]

StockCharts.com - Introduction to Candlesticks

Compared to traditional bar charts, many traders consider candlestick charts more visually appealing and easier to interpret. Each candlestick provides an easy-to-decipher picture of price action. Immediately a trader can see compare the relationship between the open and close as well as the high and low. The relationship between the open and close is considered vital information and forms the essence of candlesticks. White candlesticks, where the close is greater than the open, indicate buying pressure. Black candlesticks, where the close is less than the open, indicate selling pressure. Long versus Short Bodies Generally speaking, the longer the body is, the more intense the buying or selling pressure. Conversely, short candlesticks indicate little price movement and represent consolidation.

http://www.stockcharts.com/education/What/ChartAnalysis/candlesticks-print.html (3 of 8) [2/18/2003 5:08:55 AM]

StockCharts.com - Introduction to Candlesticks

Long white candlesticks show strong buying pressure. The longer the white candlestick is, the further the close is above the open. This indicates that prices advanced significantly from open to close and buyers were aggressive. While long white candlesticks are generally bullish, much depends on their position within the broader technical picture. After extended declines, long white candlesticks can mark a potential turning point or support level. If buying gets too aggressive after a long advance, it can lead to excessive bullishness. Long black candlesticks show strong selling pressure. The longer the black candlestick is, the further the close is below the open. This indicates that prices declined significantly from the open and sellers were aggressive. After a long advance, a long black candlestick can foreshadow a turning point or mark a future resistance level. After a long decline a long black candlestick can indicate panic or capitulation.

http://www.stockcharts.com/education/What/ChartAnalysis/candlesticks-print.html (4 of 8) [2/18/2003 5:08:55 AM]

StockCharts.com - Introduction to Candlesticks

Even more potent long candlesticks are the Marubozu brothers, Black and White. Marubozu do not have upper or lower shadows and the high and low are represented by the open or close. A White Marubozu forms when the open equals the low and the close equals the high. This indicates that buyers controlled the price action from the first trade to the last trade. Black Marubozu form when the open equals the high and the close equals the low. This indicates that sellers controlled the price action from the first trade to the last trade. Long versus Short Shadows The upper and lower shadows on candlesticks can provide valuable information about the trading session. Upper shadows represent the session high and lower shadows the session low. Candlesticks with short shadows indicate that most of the trading action was confined near the open and close. Candlestick with long shadows show that traded extended well past the open and close.

http://www.stockcharts.com/education/What/ChartAnalysis/candlesticks-print.html (5 of 8) [2/18/2003 5:08:55 AM]

StockCharts.com - Introduction to Candlesticks

Candlesticks with a long upper shadow and short lower shadow indicate that buyers dominated during the session and bid prices higher. However, sellers later forced prices down off of their highs and the weak close created a long upper shadow. Conversely, candlesticks with long lower shadows and short upper shadows indicate that sellers dominated during the session and drove prices lower. However, buyers later resurfaced to bid prices higher by the end of the session and the strong close created a long lower shadow.

http://www.stockcharts.com/education/What/ChartAnalysis/candlesticks-print.html (6 of 8) [2/18/2003 5:08:55 AM]

StockCharts.com - Introduction to Candlesticks

Candlesticks with a long upper shadow, long lower shadow and small real body are called spinning tops. One long shadow represents a reversal of sorts; spinning tops represent indecision. The small real body (whether hollow or filled) shows little movement from open to close, and the shadows indicate that both bulls and bears were active during the session. Even though the session opened and closed with little change, prices moved significantly higher and lower in the mean time. Neither buyers nor sellers could gain the upper hand and the result was a standoff. After a long advance or long white candlestick, a spinning top indicates weakness among the bulls and a potential change or interruption in trend. After a long decline or long black candlestick, a spinning top indicates weakness among the bears and a potential change or interruption in trend.

Written by Arthur Hill Part 1 | Part 2| Part 3 | Part 4

Send us your Feedback!

http://www.stockcharts.com/education/What/ChartAnalysis/candlesticks-print.html (7 of 8) [2/18/2003 5:08:55 AM]

StockCharts.com - Introduction to Candlesticks

©2002 StockCharts.com All Rights Reserved Terms of Use

http://www.stockcharts.com/education/What/ChartAnalysis/candlesticks-print.html (8 of 8) [2/18/2003 5:08:55 AM]

StockCharts.com - Introduction to Candlesticks Part 2

Introduction to Candlesticks Part 2 Doji Doji are important candlesticks that provide information on their own and also feature in a number of important patterns. Doji form when a security's open and close are virtually equal. The length of the upper and lower shadows can vary and the resulting candlestick looks like a cross, inverted cross or plus sign. Alone, doji are neutral patterns. Any bullish or bearish bias is based on preceding price action and future confirmation. The word "Doji" refers to both the singular and plural form.

Ideally, but not necessarily, the open and close should be equal. While a doji with an equal open and close would be considered more robust, it is more important to capture the essence of the candlestick. Doji convey a sense of indecision or tug-of-war between buyers and sellers. Prices move above and below the opening level during the session, but close at or near the opening level. The result is a standoff. Neither bulls nor bears were able to gain control and a turning point could be developing.

http://www.stockcharts.com/education/What/ChartAnalysis/candlesticks2-print.html (1 of 7) [2/18/2003 5:09:09 AM]

StockCharts.com - Introduction to Candlesticks Part 2

Different securities have different criteria for determining the robustness of a doji. A $20 stock could form a doji with a 1/8 point difference between open and close, while a $200 stock might form one with a 1 1/4 point difference. Determining the robustness of the doji will depend on the price, recent volatility and previous candlesticks. Relative to previous candlesticks, the doji should have a very small body that appears as a thin line. Steven Nison notes that a doji that forms among other candlesticks with small real bodies would not be considered important. However, a doji that forms among candlesticks with long real bodies would be deemed significant. Doji and Trend The relevance of a doji depends on the preceding trend or preceding candlesticks. After an advance, or long white candlestick, a doji signals that the buying pressure is starting to weaken. After a decline, or long black candlestick, a doji signals that selling pressure is starting to diminish. Doji indicate that the forces of supply and demand are becoming more evenly matched and a change in trend may be near. Doji alone are not enough to mark a reversal and further confirmation may be warranted.

http://www.stockcharts.com/education/What/ChartAnalysis/candlesticks2-print.html (2 of 7) [2/18/2003 5:09:09 AM]

StockCharts.com - Introduction to Candlesticks Part 2

After an advance or long white candlestick, a doji signals that buying pressure may be diminishing and the uptrend could be nearing an end. Whereas a security can decline simply from a lack of buyers, continued buying pressure is required to sustain an uptrend. Therefore, a doji may be more significant after an uptrend or long white candlestick. Even after the doji forms, further downside is required for bearish confirmation. This may come as a gap down, long black candlestick, or decline below the long white candlestick's open. After a long white candlestick and doji, traders should be on the alert for a potential evening doji star.

http://www.stockcharts.com/education/What/ChartAnalysis/candlesticks2-print.html (3 of 7) [2/18/2003 5:09:09 AM]

StockCharts.com - Introduction to Candlesticks Part 2

After a decline or long black candlestick, a doji indicates that selling pressure may be diminishing and the downtrend could be nearing an end. Even though the bears are starting to lose control of the decline, further strength is required to confirm any reversal. Bullish confirmation could come from a gap up, long white candlestick or advance above the long black candlestick's open. After a long black candlestick and doji, traders should be on the alert for a potential morning doji star. Long-legged Doji

http://www.stockcharts.com/education/What/ChartAnalysis/candlesticks2-print.html (4 of 7) [2/18/2003 5:09:09 AM]

StockCharts.com - Introduction to Candlesticks Part 2

Long-legged doji have long upper and lower shadows that are almost equal in length. These doji reflect a great amount of indecision in the market. Long-legged doji indicate that prices traded well above and below the session's opening level, but closed virtually even with the open. After a whole lot of yelling and screaming, the end result showed little change from the initial open. Dragon Fly Doji

http://www.stockcharts.com/education/What/ChartAnalysis/candlesticks2-print.html (5 of 7) [2/18/2003 5:09:09 AM]

StockCharts.com - Introduction to Candlesticks Part 2

Dragon fly doji form when the open, high and close are equal and the low creates a long lower shadow. The resulting candlestick looks like a "T" with a long lower shadow and no upper shadow. Dragon fly doji indicate that sellers dominated trading and drove prices lower during the session. By the end of the session, buyers resurfaced and pushed prices back to the opening level and the session high. The reversal implications of a dragon fly doji depend on previous price action and future confirmation. The long lower shadow provides evidence of buying pressure, but the low indicates that plenty of sellers still loom. After a long downtrend, long black candlestick or at support, a dragon fly doji could signal a potential bullish reversal or bottom. After a long uptrend, long white candlestick or at resistance, the long lower shadow could foreshadow a potential bearish reversal or top. Bearish or bullish confirmation is required for both situations. Gravestone Doji Gravestone doji form when the open, low and close are equal and the high creates a long upper shadow. The resulting candlestick looks like an upside down "T" with a long upper shadow and no lower shadow. Gravestone doji indicate that buyers dominated trading and drove prices higher during the session. However, by the end of the session, sellers resurfaced and pushed prices back to the opening level and the session low. As with the dragon fly doji and other candlesticks, the reversal implications of gravestone doji depend on previous price action and future confirmation. Even though the long upper shadow indicates a failed rally, the intraday high provides evidence of some buying pressure. After a long downtrend, long black candlestick or at support, http://www.stockcharts.com/education/What/ChartAnalysis/candlesticks2-print.html (6 of 7) [2/18/2003 5:09:09 AM]

StockCharts.com - Introduction to Candlesticks Part 2

focus turns to the evidence of buying pressure and a potential bullish reversal. After a long uptrend, long white candlestick or at resistance, focus turns to the failed rally and a potential bearish reversal. Bearish or bullish confirmation is required for both situations.

Written by Arthur Hill Part 1 | Part 2 | Part 3 | Part 4

Send us your Feedback!

©2002 StockCharts.com All Rights Reserved Terms of Use

http://www.stockcharts.com/education/What/ChartAnalysis/candlesticks2-print.html (7 of 7) [2/18/2003 5:09:09 AM]

StockCharts.com - Introduction to Candlesticks Part 3

Introduction to Candlesticks Part 3 Before turning to the single and multiple candlestick patterns, there are a few general guidelines to cover. Bulls vs. Bears A candlestick depicts the battle between Bulls (buyers) and Bears (sellers) over a given period of time. An analogy to this battle can be made between two football teams, which we can also call the Bulls and the Bears. The bottom (intra-session low) of the candlestick represents a touchdown for the Bears and the top (intra-session high) a touchdown for the Bulls. The closer the close is to the high, the closer the Bulls are to a touchdown. The closer the close is to the low, the closer the Bears are to a touchdown. While there are many variations, I have narrowed the field to 6 types of games (or candlesticks):

1. Long white candlesticks indicate that the Bulls controlled the ball (trading) for most of the game. 2. Long black candlesticks indicate that the Bears controlled the ball (trading) for most of the game.

http://www.stockcharts.com/education/What/ChartAnalysis/candlesticks3-print.html (1 of 5) [2/18/2003 5:09:36 AM]

StockCharts.com - Introduction to Candlesticks Part 3

3. Small candlesticks indicate that neither team could move the ball and prices finished about where they started. 4. A long lower shadow indicates that the Bears controlled the ball for part of the game, but lost control by the end and the Bulls made an impressive comeback. 5. A long upper shadow indicates that the Bulls controlled the ball for part of the game, but lost control by the end and the Bears made an impressive comeback. 6. A long upper and lower shadow indicates that the both the Bears and the Bulls had their moments during the game, but neither could put the other away, resulting in a standoff. What Candlesticks Don't Tell You Candlesticks do not reflect the sequence of events between the open and close, only the relationship between the open and the close. The high and the low are obvious and indisputable, but candlesticks (and bar charts) cannot tell us which came first.

With a long white candlestick, the assumption is that prices advanced most of the session. However, based on the high/low sequence, the session could have been more volatile. The example above depicts two possible high/low sequences that would form the same candlestick. The first sequence shows two small moves and one large move: a small decline off the open to form the low, a sharp advance to form the high and a small decline to form the close. The second sequence shows three rather sharp moves: a sharp advance off the open to form the high, a sharp decline to form the low and a sharp advance to form the close. The first sequence portrays strong sustained buying pressure and would be considered more bullish. The second sequence reflects more volatility and some selling pressure. These are just two examples and there are http://www.stockcharts.com/education/What/ChartAnalysis/candlesticks3-print.html (2 of 5) [2/18/2003 5:09:36 AM]

StockCharts.com - Introduction to Candlesticks Part 3

hundreds of potential combinations that could result in the same candlestick. Candlesticks still offer valuable information on the relative positions of the open, high, low and close. However, the trading activity that forms a particular candlestick can vary. Prior Trend In his book, Candlestick Charting Explained, Greg Morris notes that for a pattern to qualify as a reversal pattern, there should be a prior trend to reverse. Bullish reversals require a preceding downtrend and bearish reversals require a prior uptrend. The direction of the trend can be determined using trendlines, moving averages, peak/trough analysis or other aspects of technical analysis. A downtrend might exist as long as the security was trading below its down trendline, below its previous reaction high or below a specific moving average. The length and duration will depend on individual preferences. However, because candlesticks are short-term in nature, it is usually best to consider the last 1-4 weeks of price action. Candlestick Positioning

Star Position A candlestick that gaps away from the previous candlestick is said to be in star position. The first candlestick usually has a large real body, but not always, and the second candlestick in star position has a small real body. Depending on the previous candlestick, the star position candlestick gaps up or down and appears isolated from previous price action. The two candlesticks can be any combination of white and black. Doji, hammers, shooting stars and spinning tops have small real bodies and can form in the star position. Later we will examine 2- and 3-candlestick patterns that utilize the star position. http://www.stockcharts.com/education/What/ChartAnalysis/candlesticks3-print.html (3 of 5) [2/18/2003 5:09:36 AM]

StockCharts.com - Introduction to Candlesticks Part 3

Harami Position A candlestick that forms within the real body of the previous candlestick is in Harami position. Harami means pregnant in Japanese and the second candlestick is nestled inside the first. The first candlestick usually has a large real body and the second a smaller real body than the first. The shadows (high/low) of the second candlestick do not have to be contained within the first, though it's preferable if they are. Doji and spinning tops have small real bodies and can form in the harami position as well. Later we will examine candlestick patterns that utilize the harami position.

Written by Arthur Hill Part 1 | Part 2 | Part 3 | Part 4

Send us your Feedback!

http://www.stockcharts.com/education/What/ChartAnalysis/candlesticks3-print.html (4 of 5) [2/18/2003 5:09:36 AM]

StockCharts.com - Introduction to Candlesticks Part 3

©2002 StockCharts.com All Rights Reserved Terms of Use

http://www.stockcharts.com/education/What/ChartAnalysis/candlesticks3-print.html (5 of 5) [2/18/2003 5:09:36 AM]

StockCharts.com - Introduction to Candlesticks Part 4

Introduction to Candlesticks Part 4 Long Shadow Reversals There are two pair of single candlestick reversal patterns made up of a small real body, one long shadow and one short or non-existent shadow. Generally, the long shadow should be at least twice the length of the real body, which can be either black or white. The location of the long shadow and preceding price action determine the classification. The first pair, hammer and hanging man, are identical with small bodies and long lower shadows. The second pair, shooting star and inverted hammer, are also identical with small bodies and long upper shadows. Only preceding price action and further confirmation determine the bullish or bearish nature of these candlesticks. The hammer and inverted hammer form after a decline and are bullish reversal patterns, while the shooting star and hanging man form after an advance and are bearish reversal patterns. Hammer and Hanging Man

The hammer and hanging man look exactly alike, but have different implications based on the preceding price action. Both have small real bodies (black or white), long lower shadows and short or non-existent upper shadows. As with most single and double http://www.stockcharts.com/education/What/ChartAnalysis/candlesticks4-print.html (1 of 7) [2/18/2003 5:09:51 AM]

StockCharts.com - Introduction to Candlesticks Part 4

candlestick formations, the hammer and hanging man require confirmation before action.

The hammer is a bullish reversal pattern that forms after a decline. In addition to a potential trend reversal, hammers can mark bottoms or support levels. After a decline, hammers signal a bullish revival. The low of the long lower shadow implies that sellers drove prices lower during the session. However, the strong finish indicates that buyers regained their footing to end the session on a strong note. While this may seem enough to act on, hammers require further bullish confirmation. The low of the hammer shows that plenty of sellers remain. Further buying pressure, and preferably on expanding volume, is needed before acting. Such confirmation could come from a gap up or long white candlestick. Hammers are similar to selling climaxes and heavy volume can serve to reinforce the validity of the reversal. The hanging man is a bearish reversal pattern that can also mark a top or resistance level. Forming after an advance, a hanging man signals that selling pressure is starting to increase. The low of the long lower shadow confirms that sellers pushed prices lower during the session. Even though the bulls regained their footing and drove prices higher by the finish, the appearance of selling pressure raises the yellow flag. As with the hammer, a hanging man requires bearish confirmation before action. Such confirmation can come as a gap down or long black candlestick on heavy volume. Inverted Hammer and Shooting Star

http://www.stockcharts.com/education/What/ChartAnalysis/candlesticks4-print.html (2 of 7) [2/18/2003 5:09:51 AM]

StockCharts.com - Introduction to Candlesticks Part 4

The inverted hammer and shooting star look exactly alike, but have different implications based on previous price action. Both candlesticks have small real bodies (black or white), long upper shadows and small or non-existent lower shadows. These candlesticks mark potential trend reversals, but require confirmation before action.

http://www.stockcharts.com/education/What/ChartAnalysis/candlesticks4-print.html (3 of 7) [2/18/2003 5:09:51 AM]

StockCharts.com - Introduction to Candlesticks Part 4

The shooting star is a bearish reversal pattern that forms after an advance and in the star position, hence its name. A shooting star can mark a potential trend reversal or resistance level. The candlestick forms when prices gap higher on the open, advance during the session and close well off their highs. The resulting candlestick has a long upper shadow and small black or white body. After a large advance (the upper shadow), the ability of the bears to force prices down raises the yellow flag. To indicate a substantial reversal, the upper shadow should relatively long and at least 2 times the length of the body. Bearish confirmation is required after the shooting star and can take the form of a gap down or long black candlestick on heavy volume. The inverted hammer looks exactly like a shooting star, but forms after a decline or downtrend. Inverted hammers represent a potential trend reversal or support levels. After a decline, the long upper shadow indicates buying pressure during the session. However, the bulls were not able to sustain this buying pressure and prices closed well off of their highs to create the long upper shadow. Because of this failure, bullish confirmation is required before action. An inverted hammer followed by a gap up or long white candlestick with heavy volume could act as bullish confirmation. Blending Candlesticks Candlestick patterns are made up of one or more candlesticks and these can be blended together to form one candlestick. This blended candlestick captures the essence of the pattern and can be formed using the following: ● ● ●

The open of first candlestick The close of the last candlestick The high and low of the pattern

http://www.stockcharts.com/education/What/ChartAnalysis/candlesticks4-print.html (4 of 7) [2/18/2003 5:09:51 AM]

StockCharts.com - Introduction to Candlesticks Part 4

By using the open of the first candlestick, close of the second candlestick and high/low of the pattern, a bullish engulfing or piercing pattern blends into a hammer. The long lower shadow of the hammer signals a potential bullish reversal. As with the hammer, both the bullish engulfing and piercing pattern require bullish confirmation.

http://www.stockcharts.com/education/What/ChartAnalysis/candlesticks4-print.html (5 of 7) [2/18/2003 5:09:51 AM]

StockCharts.com - Introduction to Candlesticks Part 4

Blending the candlesticks of a bearish engulfing or dark cloud pattern creates a shooting star. The long upper shadow of the shooting star indicates a potential bearish reversal. As with the shooting star, bearish engulfing and dark cloud cover patterns require bearish confirmation.

More than two candlesticks can be blended using the same guidelines: open from the first, close from the last and high/low of the pattern. Blending three white soldiers creates a long white candlestick and blending three black crows creates a long black candlestick.

Written by Arthur Hill Part 1 | Part 2| Part 3 | Part 4

Send us your Feedback!

http://www.stockcharts.com/education/What/ChartAnalysis/candlesticks4-print.html (6 of 7) [2/18/2003 5:09:51 AM]

StockCharts.com - Introduction to Candlesticks Part 4

©2002 StockCharts.com All Rights Reserved Terms of Use

http://www.stockcharts.com/education/What/ChartAnalysis/candlesticks4-print.html (7 of 7) [2/18/2003 5:09:51 AM]

StockCharts.com - Candlesticks and Support

Candlesticks and Support Single candlesticks and candlestick patterns can be used to confirm or mark support levels. Such a support level could be new after an extended decline or confirm a previous support level within a trading range. In a trading range, candlesticks can help choose entry points for buying near support and selling near resistance. The list below contains some, but not all, of the candlesticks and candlestick patterns that can be used to together with support levels. The bullish reversal patterns are marked (R). ● ● ● ● ● ● ● ● ● ●

Bullish Engulfing (R) Bullish Harami (R) Doji (Normal, Long Legged, Dragon Fly) Hammer (R) Inverted Hammer (R) Long White candlestick or White Marubozu Morning Star or Bullish Abandoned Baby (R) Piercing Pattern (R) Spinning Top Three White Soldiers (R)

Bullish reversal candlesticks and patterns suggest that early selling pressure was overcome and buying pressure emerged for a strong finish. Such bullish price action indicates strong demand and that support may be found. The inverted hammer, long white candlestick and marubozu show increased buying pressure rather than an actual price reversal. With its long upper shadow, an inverted hammer signifies intra-session buying interest that faded by the finish. Even though the security finished well below its high, the ability of buyers to push prices higher during the session is bullish. The long white candlestick and white marubozu signify sustained buying pressure in which prices advanced sharply from open to close. Signs of increased buying pressure bode well for support. The doji and spinning top denote indecision and are generally considered neutral. These non-reversal patterns indicate a decrease in selling pressure, but not necessarily a revival of buying pressure. After a decline, the appearance of a doji or spinning top denotes a sudden letup in selling pressure. A stand-off has developed between buyers and sellers, and a support level may form.

http://www.stockcharts.com/education/What/ChartAnalysis/candlesticksupport-print.html (1 of 4) [2/18/2003 5:13:10 AM]

StockCharts.com - Candlesticks and Support

Note: All of the patterns above will be covered in this candlestick series in the next few weeks.

Electronic Data Systems (EDS) traded in a range bound by 58 and 75 for about 4 months at the beginning of 2000. Support at 58 was first established in early January and resistance at 75 in late January. The stock declined to its previous support level in early March, formed a long legged doji and later a spinning top (red circle). Notice that the doji formed immediately after a long black Marubozu (long black candlestick without upper or lower shadows). This doji marked a sudden decrease in relative selling pressure and support held. Support was tested again in April and this test was also marked by a long legged doji (blue arrow).

http://www.stockcharts.com/education/What/ChartAnalysis/candlesticksupport-print.html (2 of 4) [2/18/2003 5:13:10 AM]

StockCharts.com - Candlesticks and Support

Broadcom (BRCM) formed a bullish engulfing pattern to mark a new support level just below 210 (green oval) in late July 2000. A few days later a long white candlestick formed and engulfed the previous 4 candlesticks. The combination of the bullish engulfing and long white candlestick served to reinforce the validity of support around 208. The stock has since tested support around 208 once in early September and twice in October. A piercing pattern (red arrow) formed in early October and a large hammer in late October.

http://www.stockcharts.com/education/What/ChartAnalysis/candlesticksupport-print.html (3 of 4) [2/18/2003 5:13:10 AM]

StockCharts.com - Candlesticks and Support

Medtronic (MDT) established support around 46 in late February with a spinning top (red arrow) and early March with a harami. The stock declined sharply in April and formed a hammer to confirm support at 46 (green arrow). After a reaction rally to resistance around 57, the stock again declined sharply and again found support around 46 (blue arrow). The black candlestick with the long lower shadow marked support, but the body was too big to qualify as a hammer.

Written by Arthur Hill Send us your Feedback!

©2002 StockCharts.com All Rights Reserved Terms of Use

http://www.stockcharts.com/education/What/ChartAnalysis/candlesticksupport-print.html (4 of 4) [2/18/2003 5:13:10 AM]

StockCharts.com - Candlesticks and Resistance

Candlesticks and Resistance Single candlesticks and candlestick patterns can be used to confirm or mark resistance levels. Such a resistance level could be new after an extended advance, or an existing resistance level confirmed within a trading range. In a trading range, candlesticks can help identify entry points to sell near resistance or buy near support. The list below contains some, but not all, of the candlesticks and candlestick patterns that can be used to identify or confirm resistance levels. The bearish reversal patterns are marked (R). ● ● ● ● ● ● ● ● ● ●

Bearish Engulfing (R) Bearish Harami (R) Dark Cloud Cover (R) Doji (Normal, Long Legged, Gravestone) Evening Star or Bearish Abandoned Baby (R) Hanging Man (R) Long Black Candlestick or Black Marubozu Shooting Star (R) Spinning Top Three Black Crows (R)

Bearish reversal candlesticks and patterns suggest that buying pressure was suddenly overturned and selling pressure prevailed. Such a quick reversal of fortune indicates overhead supply and a resistance level may form. The hanging man, long black candlestick and black marubozu signify increased selling pressure rather than an actual reversal. After an advance, the hanging man's long lower shadow indicates intra-session selling pressure that was overcome by the end of the session. Even though the security finished above its low, the ability of sellers to drive prices lower raises a yellow flag. The long black candlestick and black marubozu signify sustained selling pressure that moved prices significantly lower from beginning to end. Such intense selling pressure signals weakness among buyers and a resistance level may be established. The doji and spinning top show indecision and are generally considered neutral. These non-reversal patterns indicate decreased buying pressure, but no noticeable increase in selling pressure. For an advance to continue, new buyers must be willing to pay higher prices. As noted by the spinning top and doji, a standoff shows lack of conviction among buyers and a possible resistance level. http://www.stockcharts.com/education/What/ChartAnalysis/candlestickresistance-print.html (1 of 4) [2/18/2003 5:13:26 AM]

StockCharts.com - Candlesticks and Resistance

Note: All of the above patterns will be covered in this candlestick series in the next week or two.

In late May, Veritas (VRTS) advanced from 90 to 140 in about two weeks. The final jump came with a gap up and two doji. These doji marked a sudden stalemate between buyers and sellers, and a resistance level subsequently formed. After a resistance test in mid June, another doji formed to indicate that buyers lacked conviction. This led to a decline and subsequent reaction rally in early July. The advance carried the stock from 105 to 140, where another doji formed to confirm resistance set in early June.

http://www.stockcharts.com/education/What/ChartAnalysis/candlestickresistance-print.html (2 of 4) [2/18/2003 5:13:26 AM]

StockCharts.com - Candlesticks and Resistance

Lucent (LU) traded in a range bound by 65 and 52 for about 4 months. Resistance was first established in late April with a shooting star and dark cloud cover. Both of these bearish reversals were confirmed with a gap down two days later and a test of support at 52. As the stock neared support at 52, candlesticks with long lower shadow started to form and a reversal occurred at the end of May. After a sharp advance, resistance was met at 65 and another dark cloud cover formed at resistance in early June. Buyers clearly lacked conviction near 65 and sellers were all too eager to unload their stock. A final resistance test occurred in mid July. After a one day breakout above 65, the stock reversed course and closed back below 65. The rest is history.

http://www.stockcharts.com/education/What/ChartAnalysis/candlestickresistance-print.html (3 of 4) [2/18/2003 5:13:26 AM]

StockCharts.com - Candlesticks and Resistance

After a spring advance, DAL first established resistance at 57 in early April with the high of a shooting star. The stock declined sharply, but rebounded to test resistance at 57 again in May. While at resistance in May, a whole slew of shooting stars formed as well as the odd spinning top and long legged doji. The decline that broke below 56 confirmed these as bearish and the stock tested support around 50. After another advance to 57, the stock appeared to be on the verge of a breakout. However, a small white candlestick formed in mid July (black circle). The gap up may have been a positive, but the lack of followthrough signaled by the small white candlestick raised the yellow flag. The subsequent gap down formed a bearish evening star and the stock fell back to support again.

Written by Arthur Hill Send us your Feedback!

©2002 StockCharts.com All Rights Reserved Terms of Use

http://www.stockcharts.com/education/What/ChartAnalysis/candlestickresistance-print.html (4 of 4) [2/18/2003 5:13:26 AM]

StockCharts.com - Candlestick Bullish Reversals Part 1

Candlestick Bullish Reversals Part 1 There are dozens of bullish reversal candlestick patterns. I have elected to narrow the field by selecting the most popular for detailed explanations. Below are some of the key bullish reversal patterns with the number of candlesticks required in parentheses. ● ● ● ● ● ● ●

Bullish Engulfing (2) Piercing Pattern (2) Bullish Harami (2) Hammer (1) Inverted Hammer (1) Morning Star (3) Bullish Abandoned Baby (3)

The hammer and inverted hammer were covered in Introduction to Candlesticks Part 4. This article will focus on the other six patterns. For a complete list of bullish (and bearish) reversal patterns, see Greg Morris' book, Candlestick Charting Explained. Before moving on to individual patterns, certain guidelines should be established: ● ● ●

Most patterns require bullish confirmation. Bullish reversal patterns should form within a downtrend. Other aspects of technical analysis should be used as well.

Bullish Confirmation Patterns can form with one or more candlesticks; most require bullish confirmation. The actual reversal indicates that buyers overcame prior selling pressure, but it remains unclear whether new buyers will bid prices higher. Without confirmation, these patterns would be considered neutral and merely indicate a potential support level at best. Bullish confirmation means further upside followthrough and can come as a gap up, long white candlestick or high volume advance. Because candlestick patterns are short-term and usually effective for only 1 or 2 weeks, bullish confirmation should come within 1 to 3 days after the pattern. Existing Downtrend To be considered a bullish reversal, there should be an existing downtrend to reverse. A bullish engulfing at new highs can hardly be considered a bullish reversal pattern. Such formations would indicate continued buying pressure and could be considered a http://www.stockcharts.com/education/What/ChartAnalysis/candlestickbullreversal1-print.html (1 of 5) [2/18/2003 5:13:51 AM]

StockCharts.com - Candlestick Bullish Reversals Part 1

continuation pattern. In the Ciena example below, the pattern in the red oval looks like a bullish engulfing, but formed near resistance after about a 30 point advance. The pattern does show strength, but is more likely a continuation at this point than a reversal pattern.

The existence of a downtrend can be determined by using moving averages, peak/trough analysis or trendlines. A security could be deemed in a downtrend based on one of the following: ● ● ●

The security is trading below its 20-day exponential moving average (EMA). Each reaction peak and trough is lower than the previous. The security is trading below its trendline.

These are just examples of possible guidelines to determine a downtrend. Some traders may prefer shorter downtrends and consider securities below the 10-day EMA. Defining criteria will depend on your trading style and personal preferences. Other Technical Analysis http://www.stockcharts.com/education/What/ChartAnalysis/candlestickbullreversal1-print.html (2 of 5) [2/18/2003 5:13:51 AM]

StockCharts.com - Candlestick Bullish Reversals Part 1

Candlesticks provide an excellent means to identify short-term reversals, but should not be used alone. Other aspects of technical analysis can and should be incorporated to increase reversal robustness. Below are three ideas on how traditional technical analysis might be combined with candlestick analysis. 1. Support: Look for bullish reversals at support levels to increase robustness. Support levels can be identified with moving averages, previous reaction lows, trendlines or Fibonacci retracements.

Juniper Networks (JNPR) advanced from 75 to 175 in less than two months. The stock retraced about 50% of this 100 point advance and formed a large bullish engulfing pattern around 125. This pattern was confirmed with two subsequent advances above the down trendline. 2. Momentum: Use oscillators to confirm improving momentum with bullish reversals. Positive divergences in MACD, PPO, Stochastics, RSI, StochRSI or Williams %R would indicate improving momentum and increase the robustness behind a bullish reversal pattern. 3. Money Flows: Use volume-based indicators to access buying and selling pressure. On Balance Volume (OBV), Chaikin Money Flow (CMF) and the http://www.stockcharts.com/education/What/ChartAnalysis/candlestickbullreversal1-print.html (3 of 5) [2/18/2003 5:13:51 AM]

StockCharts.com - Candlestick Bullish Reversals Part 1

Accumulation/Distribution Line can be used in conjunction with candlesticks. Strength in any of these would increase the robustness of a reversal. For those that want to take it one step further, all three aspects could be combined for the ultimate signal. Look for bullish candlestick reversal in securities trading near support with positive divergences and signs of buying pressure.

http://www.stockcharts.com/education/What/ChartAnalysis/candlestickbullreversal1-print.html (4 of 5) [2/18/2003 5:13:51 AM]

StockCharts.com - Candlestick Bullish Reversals Part 1

A number of signals came together for Compaq (CPQ) in early July. After a steep decline in late June, the stock formed a series of spinning tops near support at 25. A bullish engulfing pattern formed in early July and this was confirmed three days later with a strong advance above 27. The 10-day Slow Stochastic Oscillator formed a positive divergence and moved above its trigger line just before the stock advanced above 27. Although not in the green yet, CMF showed constant improvement and moved into positive territory a week later.

Written by Arthur Hill Part 1 | Part 2

Send us your Feedback!

©2002 StockCharts.com All Rights Reserved Terms of Use

http://www.stockcharts.com/education/What/ChartAnalysis/candlestickbullreversal1-print.html (5 of 5) [2/18/2003 5:13:51 AM]

StockCharts.com - Candlestick Bullish Reversals Part 2

Candlestick Bullish Reversals Part 2 Bullish Engulfing The bullish engulfing pattern consists of two candlesticks, the first black and the second white. The size of the black candlestick is not that important, but it should not be a doji which would be relatively easy to engulf. The second should be a long white candlestick - the bigger it is, the more bullish. The white body must totally engulf the body of the first black candlestick. Ideally, though not necessarily, the white body would engulf the shadows as well. Although shadows are permitted, they are usually small or nonexistent on both candlesticks. After a decline, the second white candlestick begins to form when selling pressure causes the security to open below the previous close. Buyers step in after the open and push prices above the previous open for a strong finish and potential short-term reversal. Generally, the larger the white candlestick and the greater the engulfing, the more bullish the reversal. Further strength is required to provide bullish confirmation of this reversal pattern.

http://www.stockcharts.com/education/What/ChartAnalysis/candlestickbullreversal2-print.html (1 of 9) [2/18/2003 5:14:09 AM]

StockCharts.com - Candlestick Bullish Reversals Part 2

In Jan-00, Sun Microsystems (SUNW) formed a pair of bullish engulfing patterns that foreshadowed two significant advances. The first formed in early January after a sharp decline that took the stock well below its 20-day exponential moving average (EMA). An immediate gap up confirmed the pattern as bullish and the stock raced ahead to the mid eighties. After correcting to support, the second bullish engulfing pattern formed in late January. The stock declined below its 20-day EMA and found support from its earlier gap up. This also marked a 2/3 correction of the prior advance. A bullish engulfing pattern formed and was confirmed the next day with a strong follow-up advance. Piercing Pattern The piercing pattern is made up of two candlesticks, the first black and the second white. Both candlesticks should have fairly large bodies and the shadows are usually, but not necessarily, small or nonexistent. The white candlestick must open below the previous close and close above the midpoint of the black candlestick's body. A close below the midpoint might qualify as a reversal, but would not be considered as bullish. Just as with the bullish engulfing pattern, selling pressure forces the security to open below the previous close, indicating that sellers still have the upper hand on the open. However, buyers step in after the open to push the security higher and it closes above http://www.stockcharts.com/education/What/ChartAnalysis/candlestickbullreversal2-print.html (2 of 9) [2/18/2003 5:14:09 AM]

StockCharts.com - Candlestick Bullish Reversals Part 2

the midpoint of the previous black candlestick's body. Further strength is required to provide bullish confirmation of this reversal pattern.

In late March and early April 2000, Ciena (CIEN) declined from above 80 to around 40. The stock first touched 40 in early April with a long lower shadow. After a bounce, the stock tested support around 40 again in mid April and formed a piercing pattern. The piercing pattern was confirmed the very next day with a strong advance above 50. Even though there was a setback after confirmation, the stock remained above support and advanced above 70. Also notice the morning doji star in late May. Bullish Harami The bullish harami is made up of two candlesticks. The first has a large body and the second a small body that is totally encompassed by the first. There are four possible combinations: white/white, white/black, black/white and black/black. Whether they are bullish reversal or bearish reversal patterns, all harami look the same. Their bullish or bearish nature depends on the preceding trend. Harami are considered potential bullish reversals after a decline and potential bearish reversals after an advance. No matter what the color of the first candlestick, the smaller the body of the second candlestick is, the more likely the reversal. If the small candlestick is a doji, the chances of a reversal http://www.stockcharts.com/education/What/ChartAnalysis/candlestickbullreversal2-print.html (3 of 9) [2/18/2003 5:14:09 AM]

StockCharts.com - Candlestick Bullish Reversals Part 2

increase.

In his book Beyond Candlesticks, Steve Nison asserts that any combination of colors can form a harami, but that the most bullish are those that form with a white/black or white/white combination. Because the first candlestick has a large body, it implies that the bullish reversal pattern would be stronger if this body were white. The long white candlestick shows a sudden and sustained resurgence of buying pressure. The small candlestick afterwards indicates consolidation. White/white and white/black bullish harami are likely to occur less often than black/black or black/white. After a decline, a black/black or black/white combination can still be regarded as a bullish harami. The first long black candlestick signals that significant selling pressure remains and could indicate capitulation. The small candlestick immediately following forms with a gap up on the open, indicating a sudden increase in buying pressure and potential reversal.

http://www.stockcharts.com/education/What/ChartAnalysis/candlestickbullreversal2-print.html (4 of 9) [2/18/2003 5:14:09 AM]

StockCharts.com - Candlestick Bullish Reversals Part 2

Micromuse (MUSE) declined to the mid sixties in Apr-00 and began to trade in a range bound by 65 and 100 over the next few weeks. After a 6-day decline back to support in late May, a bullish harami (red oval) formed. The first day formed a long white candlestick, and the second a small black candlestick that could be classified as a doji. The next day's advance provided bullish confirmation and the stock subsequently rose to around 150. Hammer The hammer is made up of one candlestick, white or black, with a small body, long lower shadow and small or nonexistent upper shadow. The size of the lower shadow should be a least twice the length of the body and the high/low range should be relatively large. Large is a relative term and the high/low range should be large relative to range over the last 10-20 days. After a decline, the hammer's intraday low indicates that selling pressure remains. However, the strong close shows that buyers are starting to become active again. Further strength is required to provide bullish confirmation of this reversal pattern.

http://www.stockcharts.com/education/What/ChartAnalysis/candlestickbullreversal2-print.html (5 of 9) [2/18/2003 5:14:09 AM]

StockCharts.com - Candlestick Bullish Reversals Part 2

Nike (NKE) declined from the low fifties to the mid thirties before starting to find support in late February. After a small reaction rally, the stock declined back to support in mid March and formed a hammer. Bullish confirmation came two days later with a sharp advance. Morning Star The morning star consists of three candlesticks: 1. A long black candlestick. 2. A small white or black candlestick that gaps below the close of the previous candlestick. This candlestick can also be a doji, in which case the pattern would be a morning doji star. 3. A long white candlestick. The black candlestick confirms that the decline remains in force and selling dominates. When the second candlestick gaps down, it provides further evidence of selling pressure. However, the decline ceases or slows significantly after the gap and a small candlestick forms. The small candlestick indicates indecision and a possible reversal of trend. If the small candlestick is a doji, the chances of a reversal increase. The third http://www.stockcharts.com/education/What/ChartAnalysis/candlestickbullreversal2-print.html (6 of 9) [2/18/2003 5:14:09 AM]

StockCharts.com - Candlestick Bullish Reversals Part 2

long white candlestick provides bullish confirmation of the reversal.

After declining from above 180 to below 120, Broadcom (BRCM) formed a morning doji star and subsequently advanced above 160 in the next three days. These are strong reversal patterns and do not require further bullish confirmation, beyond the long white candlestick on the third day. After the advance above 160, a two-week pullback followed and the stock formed a piecing pattern (red arrow) that was confirmed with a large gap up. Bullish Abandoned Baby The bullish abandoned baby resembles the morning doji star and also consists of three candlesticks: 1. A long black candlestick. 2. A doji that gaps below the low of the previous candlestick. 3. A long white candlestick that gaps above the high of the doji. The main difference between the morning doji star and the bullish abandoned baby are the gaps on either side of the doji. The first gap down signals that selling pressure http://www.stockcharts.com/education/What/ChartAnalysis/candlestickbullreversal2-print.html (7 of 9) [2/18/2003 5:14:09 AM]

StockCharts.com - Candlestick Bullish Reversals Part 2

remains strong. However, selling pressure eases and the security closes at or near the open, creating a doji. Following the doji, the gap up and long white candlestick indicate strong buying pressure and the reversal is complete. Further bullish confirmation is not required.

In April, Genzyme (GENZ) declined below its 20-day EMA and began to find support in the low thirties. The stock began forming a base as early as 17-Apr, but a discernable reversal pattern failed to emerge until the end of May. The bullish abandoned baby formed with a long black candlestick, doji and long white candlestick. The gaps on either side of the doji reinforced the bullish reversal.

Written by Arthur Hill Part 1 | Part 2

http://www.stockcharts.com/education/What/ChartAnalysis/candlestickbullreversal2-print.html (8 of 9) [2/18/2003 5:14:09 AM]

StockCharts.com - Candlestick Bullish Reversals Part 2

Send us your Feedback!

©2002 StockCharts.com All Rights Reserved Terms of Use

http://www.stockcharts.com/education/What/ChartAnalysis/candlestickbullreversal2-print.html (9 of 9) [2/18/2003 5:14:09 AM]

StockCharts.com - Candlestick Bearish Reversals Part 1

Candlestick Bearish Reversals Part 1 There are dozens of bearish reversal patterns. I have elected to narrow the field by selecting a few of the most popular patterns for detailed explanations. For a complete list of bearish and bullish reversal patterns, see Greg Morris' book, Candlestick Charting Explained. Below are some of the key bearish reversal patterns, with the number of candlesticks required in parentheses. ● ● ● ● ● ●

Bearish Abandoned Baby (3) Bearish Engulfing (2) Bearish Harami (2) Dark Cloud Cover (2) Evening Star (3) Shooting Star (1)

I believe in certain guidelines relating to bearish reversal patterns: ● ● ●

Most patterns require further bearish confirmation. Bearish reversal patterns should form within an uptrend. Other aspects of technical analysis should be used as well.

Bearish Confirmation Bearish reversal patterns can form with one or more candlesticks; most require bearish confirmation. The actual reversal indicates that selling pressure overwhelmed buying pressure for one or more days, but it remains unclear whether or not sustained selling or lack of buyers will continue to push prices lower. Without confirmation, many of these patterns would be considered neutral and merely indicate a potential resistance level at best. Bearish confirmation means further downside followthrough, such as a gap down, long black candlestick or high volume decline. Because candlestick patterns are short-term and usually effective for 1-2 weeks, bearish confirmation should come within 1-3 days.

http://www.stockcharts.com/education/What/ChartAnalysis/candlestickbearreversal1-print.html (1 of 6) [2/18/2003 5:14:22 AM]

StockCharts.com - Candlestick Bearish Reversals Part 1

AOL advanced from the upper fifties to the low seventies in less than two months. The long white candlestick that took the stock above 70 in late March was followed by a longlegged doji in the harami position. A second long-legged doji immediately followed and indicated that the uptrend was beginning to tire. The dark cloud cover (red oval) increased these suspicions and bearish confirmation was provided by the long black candlestick (red arrow). Existing Uptrend To be considered a bearish reversal, there should be an existing uptrend to reverse. It does not have to be a major uptrend, but should be up for the short term or at least over the last few days. A dark cloud cover after a sharp decline or near new lows is unlikely to be a valid bearish reversal pattern. Bearish reversal patterns within a downtrend would simply confirm existing selling pressure and could be considered continuation patterns. There are many methods available to determine the trend. An uptrend can be established using moving averages, peak/trough analysis or trendlines. A security could be deemed in an uptrend based on one or more of the following:

http://www.stockcharts.com/education/What/ChartAnalysis/candlestickbearreversal1-print.html (2 of 6) [2/18/2003 5:14:22 AM]

StockCharts.com - Candlestick Bearish Reversals Part 1

● ● ●

The security is trading above its 20-day exponential moving average (EMA). Each reaction peak and trough is higher than the previous. The security is trading above a trendline.

These are just three possible methods. Some traders may prefer shorter uptrends and qualify securities that are trading above their 10-day EMA. Defining criteria will depend on your trading style, time horizon and personal preferences. Other Technical Analysis Candlesticks provide an excellent means to identify short-term reversals, but should not be used alone. Other aspects of technical analysis can and should be incorporated to increase the robustness of bearish reversal patterns. Resistance: Look for bearish reversals near resistance levels to increase robustness. Resistance levels can be determined using moving averages, previous reaction highs or trendlines.

In Jan-00, Nike (NKE) gapped up over 5 points and closed above 50. A candlestick with

http://www.stockcharts.com/education/What/ChartAnalysis/candlestickbearreversal1-print.html (3 of 6) [2/18/2003 5:14:22 AM]

StockCharts.com - Candlestick Bearish Reversals Part 1

a long upper shadow formed and the stock subsequently traded down to 45. This established a resistance level around 53. After an advance back to resistance at 53, the stock formed a bearish engulfing pattern (red oval). Bearish confirmation came when the stock declined the next day, gapped down below 50 and broke its short-term trendline two days later. Momentum: Use oscillators to confirm weakening momentum with bearish reversals. Negative divergences in MACD, PPO, Stochastics, RSI, StochRSI or Williams %R indicate weakening momentum and can increase the robustness of a bearish reversal pattern. In addition, bearish moving average crossovers in the PPO and MACD can provide confirmation, as well as trigger line crossovers for the Slow Stochastic Oscillator. Money Flows: Use volume-based indicators to assess selling pressure and confirm reversals. On Balance Volume (OBV), Chaikin Money Flow and the Accumulation/Distribution Line can be used to spot negative divergences or simply excessive selling pressure. Signs of increased selling pressure can improve the robustness of a bearish reversal pattern. For those that want to take it one step further, all three aspects could be combined for the ultimate signal. Look for a bearish candlestick reversal in securities trading near resistance with weakening momentum and signs of increased selling pressure. Such signals would be relatively rare, but could offer above-average profit potential.

http://www.stockcharts.com/education/What/ChartAnalysis/candlestickbearreversal1-print.html (4 of 6) [2/18/2003 5:14:22 AM]

StockCharts.com - Candlestick Bearish Reversals Part 1

A number of signals came together for RadioShack (RSH) in early Oct-00. The stock traded up to resistance at 70 for the third time in two months and formed a dark cloud cover pattern (red oval). In addition, the long black candlestick had a long upper shadow to indicate an intraday reversal. Bearish confirmation came the next day with a sharp decline. The negative divergence in the PPO and extremely weak money flows also provided further bearish confirmation.

http://www.stockcharts.com/education/What/ChartAnalysis/candlestickbearreversal1-print.html (5 of 6) [2/18/2003 5:14:22 AM]

StockCharts.com - Candlestick Bearish Reversals Part 1

Written by Arthur Hill Part 1 | Part 2

Send us your Feedback!

©2002 StockCharts.com All Rights Reserved Terms of Use

http://www.stockcharts.com/education/What/ChartAnalysis/candlestickbearreversal1-print.html (6 of 6) [2/18/2003 5:14:22 AM]

StockCharts.com - Candlestick Bearish Reversals Part 2

Candlestick Bearish Reversals Part 2 Bearish Engulfing The bearish engulfing pattern consists of two candlesticks; the first is white and the second black. The size of the white candlestick is not that important, but should not be a doji, which would be relatively easy to engulf. The second should be a long black candlestick. The bigger it is, the more bearish the reversal. The black body must totally engulf the body of the first, white, candlestick. Ideally, the black body should engulf the shadows as well, but this is not a requirement. Shadows are permitted, but they are usually small or nonexistent on both candlesticks. After an advance, the second black candlestick begins to form when residual buying pressure causes the security to open above the previous close. However, sellers step in after this opening gap up and begin to drive prices down. By the end of the session, selling becomes so intense that prices move below the previous close. The resulting candlestick engulfs the previous day's body and creates a potential short-term reversal. Further weakness is required for bearish confirmation of this reversal pattern.

http://www.stockcharts.com/education/What/ChartAnalysis/candlestickbearreversal2-print.html (1 of 10) [2/18/2003 5:14:39 AM]

StockCharts.com - Candlestick Bearish Reversals Part 2

After meeting resistance around 35 in mid-January, Ford (F) formed a bearish engulfing (red oval). The pattern was immediately confirmed with a decline and subsequent support break. Dark Cloud Cover The dark cloud cover pattern is made up of two candlesticks; the first is white and the second black. Both candlesticks should have fairly large bodies and the shadows are usually small or nonexistent, though not necessarily. The black candlestick must open above the previous close and close below the midpoint of the white candlestick's body. A close above the midpoint might qualify as a reversal, but would not be considered as bearish. Just as with the bearish engulfing pattern, residual buying pressure forces prices higher on the open, creating an opening gap above the white candlestick's body. However, sellers step in after the strong open and push prices lower. The intensity of the selling drives prices below the midpoint of the white candlestick's body. Further weakness is required for bearish confirmation of this reversal pattern.

http://www.stockcharts.com/education/What/ChartAnalysis/candlestickbearreversal2-print.html (2 of 10) [2/18/2003 5:14:39 AM]

StockCharts.com - Candlestick Bearish Reversals Part 2

After a sharp advance from 37 1/2 to 45 in about 2 weeks, Citigroup (C) formed a dark cloud cover pattern (red oval). This pattern was confirmed with two long black candlesticks and marked an abrupt reversal around 45. Shooting Star The shooting star is made up of one candlestick (white or black) with a small body, long upper shadow and small or nonexistent lower shadow. The size of the upper shadow should be a least twice the length of the body and the high/low range should be relatively large. Large is a relative term and the high/low range should be large relative to the range over the last 10-20 days. For a candlestick to be in star position, it must gap way from the previous candlestick. In Candlestick Charting Explained, Greg Morris indicates that a shooting star should gap up from the preceding candlestick. However, in Beyond Candlesticks, Steve Nison provides a shooting star example that forms below the previous close. There should be room to maneuver, especially when dealing with stocks and indices, which often open near the previous close. A gap up would definitely enhance the robustness of a shooting star, but the essence of the reversal should not be lost without the gap.

http://www.stockcharts.com/education/What/ChartAnalysis/candlestickbearreversal2-print.html (3 of 10) [2/18/2003 5:14:39 AM]

StockCharts.com - Candlestick Bearish Reversals Part 2

After an advance that was punctuated by a long white candlestick, Chevron (CHV) formed a shooting star candlestick above 90 (red oval). The bearish reversal pattern was confirmed with a gap down the following day . Bearish Harami The bearish harami is made up of two candlesticks. The first has a large body and the second a small body that is totally encompassed by the first. There are four possible combinations: white/white, white/black, black/white and black/black. Whether a bullish reversal or bearish reversal pattern, all harami look the same. Their bullish or bearish nature depends on the preceding trend. Harami are considered potential bearish reversals after an advance and potential bullish reversals after a decline. No matter what the color of the first candlestick, the smaller the body of the second candlestick is, the more likely the reversal. If the small candlestick is a doji, the chances of a reversal increase.

http://www.stockcharts.com/education/What/ChartAnalysis/candlestickbearreversal2-print.html (4 of 10) [2/18/2003 5:14:39 AM]

StockCharts.com - Candlestick Bearish Reversals Part 2

In his book, Beyond Candlesticks, Steve Nison asserts that any combination of colors can form a harami, but the most bearish are those that form with a black/white or black/black combination. Because the first candlestick has a large body, it implies that the bearish reversal pattern would be stronger if this body were black. This would indicate a sudden and sustained increase in selling pressure. The small candlestick afterwards indicates consolidation before continuation. After an advance, black/white or black/black bearish harami are not as common as white/black or white/white variations. A white/black or white/white combination can still be regarded as a bearish harami and signal a potential reversal. The first long white candlestick forms in the direction of the trend. It signals that significant buying pressure remains, but could also indicate excessive bullishness. Immediately following, the small candlestick forms with a gap down on the open, indicating a sudden shift towards the sellers and a potential reversal.

http://www.stockcharts.com/education/What/ChartAnalysis/candlestickbearreversal2-print.html (5 of 10) [2/18/2003 5:14:39 AM]

StockCharts.com - Candlestick Bearish Reversals Part 2

After a gap up and rapid advance to 30, Ameritrade (AMTD) formed a bearish harami (red oval). This harami consists of a long black candlestick and a small black candlestick. The decline two days later confirmed the bearish harami and the stock fell to the low twenties.

http://www.stockcharts.com/education/What/ChartAnalysis/candlestickbearreversal2-print.html (6 of 10) [2/18/2003 5:14:39 AM]

StockCharts.com - Candlestick Bearish Reversals Part 2

Merck (MRK) formed a bearish harami with a long white candlestick and long black candlestick (red oval). The long white candlestick confirmed the direction of the current trend. However, the stock gapped down the next day and traded in a narrow range. The decline three days later confirmed the pattern as bearish. Evening Star The evening star consists of three candlesticks: 1. A long white candlestick. 2. A small white or black candlestick that gaps above the close (body) of the previous candlestick. This candlestick can also be a doji, in which case the pattern would be a evening doji star. 3. A long black candlestick. The long white candlestick confirms that buying pressure remains strong and the trend is up. When the second candlestick gaps up, it provides further evidence of residual buying pressure. However, the advance ceases or slows significantly after the gap and a small candlestick forms, indicating indecision and a possible reversal of trend. If the small candlestick is a doji, the chances of a reversal increase. The third long black http://www.stockcharts.com/education/What/ChartAnalysis/candlestickbearreversal2-print.html (7 of 10) [2/18/2003 5:14:39 AM]

StockCharts.com - Candlestick Bearish Reversals Part 2

candlestick provides bearish confirmation of the reversal.

After advancing from 45 to 60 in about two weeks, AT&T (T) formed an evening star (red oval). The middle candlestick is a spinning top, which indicates indecision and possible reversal. The gap above 60 was reversed immediately with a long black candlestick. Even though the stock stabilized in the next few days, it never exceeded the top of the long black candlestick and subsequently fell below 50. Bearish Abandoned Baby The bearish abandoned baby resembles the evening doji star and also consists of three candlesticks: 1. A long white candlestick. 2. A doji that gaps above the high of the previous candlestick. 3. A long black candlestick that gaps below the low of the doji. The main difference between the evening doji star and the bearish abandoned baby are the gaps on either side of the doji. The first gap up signals a continuation of the uptrend

http://www.stockcharts.com/education/What/ChartAnalysis/candlestickbearreversal2-print.html (8 of 10) [2/18/2003 5:14:39 AM]

StockCharts.com - Candlestick Bearish Reversals Part 2

and confirms strong buying pressure. However, buying pressure subsides after the gap up and the security closes at or near the open, creating a doji. Following the doji, the gap down and long black candlestick indicate strong and sustained selling pressure to complete the reversal. Further bearish confirmation is not required.

Delta (DAL) formed an abandoned baby to mark a sharp reversal that carried the stock from 57 1/2 to 47 1/2. Although the open and close are not exactly equal, the small white candlestick in the middle captures the essence of a doji. Indecision is reflected with the small body and equal upper and lower shadows. In addition, the middle candlestick is separated by gaps on either side, which add emphasis to the reversal.

Written by Arthur Hill Part 1 | Part 2

http://www.stockcharts.com/education/What/ChartAnalysis/candlestickbearreversal2-print.html (9 of 10) [2/18/2003 5:14:39 AM]

StockCharts.com - Candlestick Bearish Reversals Part 2

Send us your Feedback!

©2002 StockCharts.com All Rights Reserved Terms of Use

http://www.stockcharts.com/education/What/ChartAnalysis/candlestickbearreversal2-print.html (10 of 10) [2/18/2003 5:14:39 AM]

StockCharts.com - Bump and Run Reversal (Reversal)

Bump and Run Reversal (Reversal) As the name implies, the Bump and Run Reversal (BARR) is a reversal pattern that forms after excessive speculation drives prices up too far, too fast. Developed by Thomas Bulkowski, the pattern was introduced in the June-97 issue of Technical Analysis of Stocks and Commodities and also included in his recently published book, the Encyclopedia of Chart Patterns. The pattern was originally named the Bump and Run Formation, or BARF. Bulkowski decided that Wall Street was not ready for such an acronym and changed the name to Bump and Run Reversal. Bulkowski identified three main phases to the pattern: lead-in, bump and run. We will examine these phases and also look at volume and pattern validation.

http://www.stockcharts.com/education/What/ChartAnalysis/barr-print.html (1 of 4) [2/18/2003 5:15:57 AM]

StockCharts.com - Bump and Run Reversal (Reversal)

1. Lead-in Phase: The first part of the pattern is a lead-in phase that can last 1 month or longer and forms the basis from which to draw the trendline. During this phase, prices advance in an orderly manner and there is no excess speculation. The trendline should be moderately steep. If it is too steep then the ensuing bump is unlikely to be significant enough. If the trendline is not steep enough, then the subsequent trendline break will occur too late. Bulkowski advises that an angle of 30 to 45 degrees is preferable. The size of the angle will depend on the scaling (semi-log or arithmetic) and the size of the chart. It is probably easier to judge the soundness of the trendline with a visual assessment. 2. Bump Phase: The bump forms with a sharp advance, and prices move further away from the lead-in trendline. Ideally, the angle of the trendline from the bump's advance should be about 50% greater than the angle of the trendline extending up from the lead-in phase. Roughly speaking, this would call for an angle between 45 and 60 degrees. If it is not possible to measure the angles, then a visual assessment will suffice. 3. Bump Validity: It is important that the bump represent a speculative advance that cannot be sustained for a long time. Bulkowski developed what he calls an "arbitrary" measuring technique to validate the level of speculation in the bump. The distance from the highest high of the bump to the lead-in trendline should be at least twice the distance from the highest high in the lead-in phase to the leadin trendline. These distances can be measured by drawing a vertical line from the highest highs to the lead-in trendline. An example is provided below. 4. Bump rollover: After speculation dies down, prices begin to peak and a top forms. Sometimes a small double top or a series of descending peaks forms. Prices begin to decline towards the lead-in trendline and the right side of the bump forms. 5. Volume: As the stock advances during the lead-in phase, volume is usually average and sometimes low. When the speculative advance begins to form the left side of the bump, volume expands as the advance accelerates. 6. Run Phase: The run phase begins when the pattern breaks support from the leadin trendline. Prices will sometimes hesitate or bounce off the trendline before breaking through. Once the break occurs, the run phase takes over and the decline continues. 7. Support turns resistance: After the trendline is broken, there is sometimes a retracement that tests the newfound resistance level. Potential support-turnedresistance levels can also be identified from the reaction lows within the bump. The Bump and Run Reversal pattern can be applied to daily, weekly or monthly charts. As stated above, the pattern is designed to identify speculative advances that are unsustainable for a long period. Because prices rise very fast to form the left side of the bump, the subsequent decline can be just as ferocious.

http://www.stockcharts.com/education/What/ChartAnalysis/barr-print.html (2 of 4) [2/18/2003 5:15:57 AM]

StockCharts.com - Bump and Run Reversal (Reversal)

Level Three Communications ( LVLT) formed a Bump and Run Reversal pattern after prices advanced in a speculative frenzy at the beginning of 2000. Prices advanced from 72 to 132 in 2 months and this advance ultimately proved unsustainable. ●

●

●

The lead-in phase formed over a 3 month period from early Oct-99 to early Jan00. Volume during this phase was relatively subdued and actually declined during the November and December advance. The trendline extending up from the lead-in phase lows formed a 34 degree angle. A visual assessment also reveals that this trendline is neither too steep nor too flat. The bump phase began in early January when the advance accelerated with a large increase in volume. A conservatively drawn trendline formed a 51 degree angle that was exactly 50% larger than the angle from the lead-in trendline.

http://www.stockcharts.com/education/What/ChartAnalysis/barr-print.html (3 of 4) [2/18/2003 5:15:57 AM]

StockCharts.com - Bump and Run Reversal (Reversal) ●

●

●

The distance from the lead-in phase's highest high to the trendline was 13. The distance from the Bump Phase's highest high to the trendline was 38. This is almost three times larger and validates the speculative excesses in the bump. After reaching a high around 132, prices declined sharply and bounced off the lead-in trendline. A lower high formed around 115 (red arrow) and the trendline was soon broken. The decline continued after the trendline break and reached 67 before a reaction rally began. The reaction rally advanced to around 95, but fell just short of the horizontal support line before falling back to new lows.

Written by Arthur Hill Send us your Feedback!

©2002 StockCharts.com All Rights Reserved Terms of Use

http://www.stockcharts.com/education/What/ChartAnalysis/barr-print.html (4 of 4) [2/18/2003 5:15:57 AM]

StockCharts.com - Double Top (Reversal)

Double Top (Reversal) The double top is a major reversal pattern that forms after an extended uptrend. As its name implies, the pattern is made up of two consecutive peaks that are roughly equal, with a moderate trough in between.

Although there can be variations, the classic double top marks at least an intermediate change, if not long-term change, in trend from bullish to bearish. Many potential double tops can form along the way up, but until key support is broken, a reversal cannot be confirmed. To help clarify, we will look at the key points in the formation and then walk through an example. 1. Prior Trend: With any reversal pattern, there must be an existing trend to http://www.stockcharts.com/education/What/ChartAnalysis/doubleTop-print.html (1 of 5) [2/18/2003 5:16:09 AM]

StockCharts.com - Double Top (Reversal)

2. 3.

4.

5.

6.

7. 8.

reverse. In the case of the double top, a significant uptrend of several months should be in place. First Peak: The first peak should mark the highest point of the current trend. As such, the first peak is fairly normal and the uptrend is not in jeopardy (or in question) at this time. Trough: After the first peak, a decline takes place that typically ranges from 10 to 20%. Volume on the decline from the first peak is usually inconsequential. The lows are sometimes rounded or drawn out a bit, which can be a sign of tepid demand. Second peak: The advance off the lows usually occurs with low volume and meets resistance from the previous high. Resistance from the previous high should be expected. Even after meeting resistance, only the possibility of a double top exists. The pattern still needs to be confirmed. The time period between peaks can vary from a few weeks to many months, with the norm being 1-3 months. While exact peaks are preferable, there is some leeway. Usually a peak within 3% of the previous high is adequate. Decline from peak: The subsequent decline from the second peak should witness an expansion in volume and/or an accelerated descent, perhaps marked with a gap or two. Such a decline shows that the forces of demand are weaker than supply and a support test is imminent. Support break: Even after trading down to support, the double top and trend reversal are still not complete. Breaking support from the lowest point between the peaks completes the double top. This too should occur with an increase in volume and/or an accelerated descent. Support turned resistance: Broken support becomes potential resistance and there is sometimes a test of this newfound resistance level with a reaction rally. Such a test can offer a second chance to exit a position or initiate a short. Price Target: The distance from support break to peak can be subtracted from the support break for a price target. This would infer that the bigger the formation is, the larger the potential decline.

While the double top formation may seem straightforward, technicians should take proper steps to avoid deceptive double tops. The peaks should be separated by about a month. If the peaks are too close, they could just represent normal resistance rather than a lasting change in the supply/demand picture. Ensure that the low between the peaks declines at least 10%. Declines less than 10% may not be indicative of a significant increase in selling pressure. After the decline, analyze the trough for clues on the strength of demand. If the trough drags on a bit and has trouble moving back up, demand could be drying up. When the security does advance, look for a contraction in volume as a further indication of weakening demand. Perhaps the most important aspect of a double top is to avoid jumping the gun. Wait for support to be broken in a convincing manner, and usually with an expansion of volume. A price or time filter can be applied to differentiate between valid and false support breaks. A price filter might require a 3% support break before validation. A time filter might require the support break to hold for 3 days before considering it valid. The trend http://www.stockcharts.com/education/What/ChartAnalysis/doubleTop-print.html (2 of 5) [2/18/2003 5:16:09 AM]

StockCharts.com - Double Top (Reversal)

is in force until proven otherwise. This applies to the double top as well. Until support is broken in a convincing manner, the trend remains up.

The double top in Ford took about 5 months to form. Even after the support break, there was another test of newfound resistance almost 4 months later. 1. From a low near 20 in Mar-97, Ford advanced to 66 1/2 by Dec-98. The trendline extending up from Mar-97 is an internal trendline and Ford held above it until the break in May-99. 2. From the first peak, the stock declined around 17% to form the trough. 3. After reaching a low near 56 1/2 in early Feb, the trough formed over the next 2 months and there wasn't a rally until early April. This long drawn out low suggested tepid demand. http://www.stockcharts.com/education/What/ChartAnalysis/doubleTop-print.html (3 of 5) [2/18/2003 5:16:09 AM]

StockCharts.com - Double Top (Reversal)

4. The rally from 56 1/2 to 67.88 occurred on fairly good volume, but money flows barely surpassed +10%. The high at 67 7/8 was about 2% higher than the previous high, but within the 3% threshold. The distance between the two peaks was about 3 months. 5. The decline from 67 7/8 occurred with two gaps down and increased volume. Furthermore, Chaikin Money Flow promptly moved below -10%. The speed with which money flows deteriorated indicated a serious increase in selling pressure. 6. In late May and early June, the stock traded for about 3 weeks at support from the previous low. During this time, money flows declined below -20%. Even though the situation looked ominous, the double formation would not be complete until support was broken. 7. Support was broken in early June when the stock fell below 53, which was more than 3% below support at 56. After this sharp drop, there was an equally sharp advance back above the newfound resistance level. While a test of broken support can be expected, it is usually not quite this early. The advance to 58 5/8 in late June may have triggered some unpleasant short covering for those who jumped in on the first support break. The stock fell to 46 1/4 and then began the retracement advance that would ultimately test support.

On the second chart, 56 marked the support turned resistance level and 57 marked a 50% retracement of the decline from 67 7/8 to 46 1/4. Combined with the price action in early June and early July, a resistance zone could probably be established between 56 and 57. The stock subsequently formed a lower high at 55 in Jan-00 and declined to http://www.stockcharts.com/education/What/ChartAnalysis/doubleTop-print.html (4 of 5) [2/18/2003 5:16:09 AM]

StockCharts.com - Double Top (Reversal)

around 40 by mid-March.

Written by Arthur Hill Send us your Feedback!

©2002 StockCharts.com All Rights Reserved Terms of Use

http://www.stockcharts.com/education/What/ChartAnalysis/doubleTop-print.html (5 of 5) [2/18/2003 5:16:09 AM]

StockCharts.com - Double Bottom (Reversal)

Double Bottom (Reversal) The double bottom is a major reversal pattern that forms after an extended downtrend. As its name implies, the pattern is made up of two consecutive troughs that are roughly equal, with a moderate peak in between.

Although there can be variations, the classic double bottom usually marks an intermediate or long-term change in trend. Many potential double bottoms can form along the way down, but until key resistance is broken, a reversal cannot be confirmed. To help clarify, we will look at the key points in the formation and then walk through an example. 1. Prior Trend: With any reversal pattern, there must be an existing trend to http://www.stockcharts.com/education/What/ChartAnalysis/doubleBottom-print.html (1 of 4) [2/18/2003 5:16:25 AM]

StockCharts.com - Double Bottom (Reversal)

2. 3.

4.

5.

6.

7. 8.

reverse. In the case of the double bottom, a significant downtrend of several months should be in place. First Trough: The first trough should mark the lowest point of the current trend. As such, the first trough is fairly normal in appearance and the downtrend remains firmly in place. Peak: After the first trough, an advance takes place that typically ranges from 10 to 20%. Volume on the advance from the first trough is usually inconsequential, but an increase could signal early accumulation. The high of the peak is sometimes rounded or drawn out a bit from the hesitation to go back down. This hesitation indicates that demand is increasing, but still not strong enough for a breakout. Second trough: The decline off the reaction high usually occurs with low volume and meets support from the previous low. Support from the previous low should be expected. Even after establishing support, only the possibility of a double bottom exists, it still needs to be confirmed. The time period between troughs can vary from a few weeks to many months, with the norm being 1-3 months. While exact troughs are preferable, there is some room to maneuver and usually a trough within 3% of the previous is considered valid. Advance from trough: Volume is more important for the double bottom than the double top. There should clear evidence that volume and buying pressure are accelerating during the advance off of the second trough. An accelerated ascent, perhaps marked with a gap or two, also indicates a potential change in sentiment. Resistance break: Even after trading up to resistance, the double top and trend reversal are still not complete. Breaking resistance from the highest point between the troughs completes the double bottom. This too should occur with an increase in volume and/or an accelerated ascent. Resistance turned support: Broken resistance becomes potential support and there is sometimes a test of this newfound support level with the first correction. Such a test can offer a second chance to close a short position or initiate a long. Price Target: The distance from the resistance breakout to trough lows can be added on top of the resistance break to estimate a target. This would imply that the bigger the formation is, the larger the potential advance.

It is important to remember that the double bottom is an intermediate to long-term reversal pattern that will not form in a few days. Even though formation in a few weeks is possible, it is preferable to have at least 4 weeks between lows. Bottoms usually take longer than tops to form and patience can often be a virtue. Give the pattern time to develop and look for the proper clues. The advance off of the first trough should be 1020%. The second trough should form a low within 3% of the previous low and volume on the ensuing advance should increase. Volume indicators such as Chaikin Money Flow, OBV and Accumulation/Distribution can be used to look for signs of buying pressure. Just as with the double top, it is paramount to wait for the resistance breakout. The formation is not complete until the previous reaction high is taken out.

http://www.stockcharts.com/education/What/ChartAnalysis/doubleBottom-print.html (2 of 4) [2/18/2003 5:16:25 AM]

StockCharts.com - Double Bottom (Reversal)

After trending lower for almost a year, PFE formed a double bottom and broke resistance with an expansion in volume. 1. From a high near 50 in April-99, PFE declined to 30 in November-99, which was a new 52-week low. 2. The stock advanced over 20% off of its low and formed a reaction high around 37 1/2. Volume expanded and the 13-Jan advance (green arrow) occurred on the highest volume since 5-Nov. 3. After a short pullback, there was another attempt to break above resistance, but this failed. Even so, volume on advancing days was generally higher than on declining days. The ability of the stock to remain in the mid-thirties for an extended period of time indicated some strengthening in demand. 4. The decline from 37 1/2 back to 30 was sharp, but downside volume did not http://www.stockcharts.com/education/What/ChartAnalysis/doubleBottom-print.html (3 of 4) [2/18/2003 5:16:25 AM]

StockCharts.com - Double Bottom (Reversal)

expand materially. There were two days when volume on a decline exceeded the 60-day SMA and Chaikin Money Flow dipped near -10% twice. However, money flows indicated accumulation throughout the decline by remaining mostly above zero with periodic movements above +10%. 5. The second trough formed with a low exactly equal to the previous low (30) and a little over 2 months separated the lows. 6. The advance off of the second low witnessed an accelerated move with an expansion of volume. After the second low at 30, 5 of the next 6 advancing days saw volume well above the 60-day SMA. Chaikin Money Flow, which never really weakened, moved above +20% within 6 days of the low. 7. Resistance at 37 1/2 was broken with a gap up on the open and another volume expansion. After running from 30 to 40 in a few weeks, the stock pulled back to the resistance break at 37 1/2, which now turned into support. There was a brief chance to get in on the pullback and the stock quickly advanced past 45.

Written by Arthur Hill Send us your Feedback!

©2002 StockCharts.com All Rights Reserved Terms of Use

http://www.stockcharts.com/education/What/ChartAnalysis/doubleBottom-print.html (4 of 4) [2/18/2003 5:16:25 AM]

StockCharts.com - Head and Shoulders Top (Reversal)

Head and Shoulders Top (Reversal) A head and shoulders reversal pattern forms after an uptrend, and its completion marks a trend reversal. The pattern contains three successive peaks with the middle peak (head) being the highest and the two outside peaks (shoulders) being low and roughly equal. The reaction lows of each peak can be connected to form support, or a neckline.

As its name implies, the head and shoulders reversal pattern is made up of a left shoulder, head, right shoulder and neckline. Other parts playing a role in the pattern are volume, the breakout, price target and support turned resistance. We will look at each part individually and then put them together with some examples. 1. Prior Trend: It is important to establish the existence of a prior uptrend for this to be a reversal pattern. Without a prior uptrend to reverse, there cannot be a head and shoulders reversal pattern, or any reversal pattern for that matter.

http://www.stockcharts.com/education/What/ChartAnalysis/headShouldersTop-print.html (1 of 6) [2/18/2003 5:16:39 AM]

StockCharts.com - Head and Shoulders Top (Reversal)

2. Left Shoulder: While in an uptrend, the left shoulder forms a peak that marks the high point of the current trend. After making this peak, a decline ensues to complete the formation of the shoulder (1). The low of the decline usually remains above the trendline, keeping the uptrend intact. 3. Head: From the low of the left shoulder, an advance begins that exceeds the previous high and marks the top of the head. After peaking, the low of the subsequent decline marks the second point of the neckline (2). The low of the decline usually breaks the uptrend line, putting the uptrend in jeopardy. 4. Right Shoulder: The advance from the low of the head forms the right shoulder. This peak is lower than the head (a lower high) and usually in line with the high of the left shoulder. While symmetry is preferred, sometimes the shoulders can be out of whack. The decline from the peak of the right shoulder should break the neckline. 5. Neckline: The neckline forms by connecting low points 1 and 2. Low point 1 marks the end of the left shoulder and the beginning of the head. Low point 2 marks the end of the head and the beginning of the right shoulder. Depending on the relationship between the two low points, the neckline can slope up, slope down or be horizontal. The slope of the neckline will affect the pattern's degree of bearishness: a downward slope is more bearish than an upward slope. Sometimes more than one low point can be used to form the neckline. 6. Volume: As the head and shoulders pattern unfolds, volume plays an important role in confirmation. Volume can be measured as an indicator (OBV, Chaikin Money Flow) or simply by analyzing volume levels. Ideally, but not always, volume during the advance of the left shoulder should be higher than during the advance of the head. This decrease in volume along with new highs that form the head serve as a warning sign. The next warning sign comes when volume increases on the decline from the peak of the head. Final confirmation comes when volume further increases during the decline of the right shoulder. 7. Neckline Break: The head and shoulders pattern is not complete and uptrend is not reversed until neckline support is broken. Ideally, this should also occur in a convincing manner with an expansion in volume. 8. Support turned resistance: Once support is broken, it is common for this same support level to turn into resistance. Sometimes, but certainly not always, the price will return to the support break and offer a second chance to sell.

http://www.stockcharts.com/education/What/ChartAnalysis/headShouldersTop-print.html (2 of 6) [2/18/2003 5:16:39 AM]

StockCharts.com - Head and Shoulders Top (Reversal)

9. Price Target: After breaking neckline support, the projected price decline is found by measuring the distance from the neckline to the top of the head. This distance is then subtracted from the neckline to reach a price target. Any price target should serve as a rough guide and other factors should be considered as well. These factors might include previous support levels, Fibonacci retracements or long-term moving averages.

Xircom (XIRC) formed a head and shoulders reversal with an upward sloping neckline. This is not the most symmetrical of patterns, but the neckline is well marked. Key points include: 1. The low at 46 1/4 marked the end of the left shoulder and the beginning of the head (1). http://www.stockcharts.com/education/What/ChartAnalysis/headShouldersTop-print.html (3 of 6) [2/18/2003 5:16:39 AM]

StockCharts.com - Head and Shoulders Top (Reversal)

2. During the advance to 72 5/8, volume soared. However, during the second advance to 75 15/16, volume tapered off significantly. 3. When the decline from 75 15/16 began, volume accelerated (note red line on volume bars). 4. The decline from 75 15/16 to 48 1/2 broke the trendline extending up from Apr99 and formed the second low point (2). 5. During the decline of the right shoulder and neckline break, volume expanded (red oval) and Chaikin Money Flow turned negative. 6. After the initial decline, there was a return to the neckline break (black arrow). Even during this decline, Chaikin Money Flow remained negative. The subsequent decline took the stock below 30. 7. The measurement from neckline to the top of the head was 27. With the neckline break at 50, this would imply a move to around 23. The April low was 29 1/8. After a decline from 75 15/16, at least a reaction rally can be expected.

http://www.stockcharts.com/education/What/ChartAnalysis/headShouldersTop-print.html (4 of 6) [2/18/2003 5:16:39 AM]

StockCharts.com - Head and Shoulders Top (Reversal)

DLJ formed a head and shoulders reversal with a horizontal neckline. Again, it isn't the prettiest head and shoulders pattern, but neckline support is well established. Key points include: 1. The low at 60 1/2 marked the end of the left shoulder and the beginning of the head (1). 2. During the advance to 100 3/4, volume soared. 3. When the decline from 100 3/4 began, volume exceeded the levels witnessed in the previous advance and Chaikin Money Flow turned negative almost immediately. 4. The decline from 100 3/4 broke the trendline extending up from Oct-98 and the ensuing low formed the second point of the neckline (2). 5. Volume increased during the decline and Chaikin Money Flow dipped below -30%, indicating serious selling pressure. 6. During the advance of the right shoulder, volume was fairly heavy, but Chaikin Money Flow remained at level indicating continued distribution. 7. The high of the right shoulder was just short of the previous reaction high in late April. The decline after this lower high saw an increase in volume as neckline support was broken. 8. The stock returned to the scene of the crime with an advance to 61 in early July. The newfound resistance level was never broken and the stock gapped down on heavy volume (red arrows) to start the decline below 40. The head and shoulders pattern is one of the most common reversal formations. It is important to remember that it occurs after an uptrend and usually marks a major trend reversal when complete. While it is preferable that the left and right shoulders be symmetrical, it is not an absolute requirement. They can be different widths as well as different heights. Identification of neckline support and volume confirmation on the break can be the most critical factors. The support break indicates a new willingness to sell at lower prices. Lower prices combined with an increase in volume indicate an increase in supply. The combination can be lethal and sometimes there is no second chance return to the support break. Measuring the expected length of the decline after the breakout can be helpful, but don't count on it for your ultimate target. As the pattern unfolds over time, other aspects of the technical picture are likely to take precedence.

Written by Arthur Hill Send us your Feedback!

http://www.stockcharts.com/education/What/ChartAnalysis/headShouldersTop-print.html (5 of 6) [2/18/2003 5:16:39 AM]

StockCharts.com - Head and Shoulders Top (Reversal)

©2002 StockCharts.com All Rights Reserved Terms of Use

http://www.stockcharts.com/education/What/ChartAnalysis/headShouldersTop-print.html (6 of 6) [2/18/2003 5:16:39 AM]

StockCharts.com - Head and Shoulders Bottom (Reversal)

Head and Shoulders Bottom (Reversal) The head and shoulders bottom is sometimes referred to as an inverse head and shoulders. The pattern shares many common characteristics with its comparable partner, but relies more on volume patterns for confirmation. As a major reversal pattern, the head and shoulders bottom forms after a downtrend, and its completion marks a change in trend. The pattern contains three successive troughs with the middle trough (head) being the deepest and the two outside troughs (shoulders) being shallower. Ideally, the two shoulders would be equal in height and width. The reaction highs in the middle of the pattern can be connected to form resistance, or a neckline.

The price action forming both head and shoulders top and head and shoulders bottom patterns remains roughly the same, but reversed. The role of volume marks the biggest difference between the two. Generally speaking, volume plays a larger role in bottom formations than top formations. While an increase in volume on the neckline breakout for a head and shoulders top is welcomed, it is absolutely required for a bottom. We will look at each part of the pattern individually, keeping volume in mind, and then put the

http://www.stockcharts.com/education/What/ChartAnalysis/headShouldersBottom-print.html (1 of 7) [2/18/2003 5:16:53 AM]

StockCharts.com - Head and Shoulders Bottom (Reversal)

parts together with some examples. 1. Prior Trend: It is important to establish the existence of a prior downtrend for this to be a reversal pattern. Without a prior downtrend to reverse, there cannot be a head and shoulders bottom formation. 2. Left Shoulder: While in a downtrend, the left shoulder forms a trough that marks a new reaction low in the current trend. After forming this trough, an advance ensues to complete the formation of the left shoulder (1). The high of the decline usually remains below any longer trendline, thus keeping the downtrend intact. 3. Head: From the high of the left shoulder, a decline begins that exceeds the previous low and forms the low point of the head. After making a bottom, the high of the subsequent advance forms the second point of the neckline (2). The high of the advance sometimes breaks a downtrend line, which calls into question the robustness of the downtrend. 4. Right Shoulder: The decline from the high of the head (neckline) begins to form the right shoulder. This low is always higher than the head and usually in line with the low of the left shoulder. While symmetry is preferred, sometimes the shoulders can be out of whack and the right shoulder will be higher, lower, wider or narrower. When the advance from the low of the right shoulder breaks the neckline, the head and shoulders reversal is complete. 5. Neckline: The neckline forms by connecting reaction highs 1 and 2. Reaction high 1 marks the end of the left shoulder and the beginning of the head. Reaction high 2 marks the end of the head and the beginning of the right shoulder. Depending on the relationship between the two reaction highs, the neckline can slope up, slope down or be horizontal. The slope of the neckline will affect the pattern's degree of bullishness: an upward slope is more bullish than downward slope. 6. Volume: While volume plays an important role in the head and shoulders top, it plays a crucial role in the head and shoulders bottom. Without the proper expansion of volume, the validity of any breakout becomes suspect. Volume can be measured as an indicator (OBV, Chaikin Money Flow) or simply by analyzing the absolute levels associated with each peak and trough. Volume levels during the first half of the pattern are less important that in the second half. Volume on the decline of the left shoulder is usually pretty heavy and selling pressure quite intense. The intensity of selling can even continue during the decline that forms the low of the head. After this low, subsequent volume http://www.stockcharts.com/education/What/ChartAnalysis/headShouldersBottom-print.html (2 of 7) [2/18/2003 5:16:53 AM]

StockCharts.com - Head and Shoulders Bottom (Reversal)

patterns should be watched carefully to look for expansion during the advances. The advance from the low of the head should show and increase in volume and/or better indicator readings (e.g. CMF > 0 or strength in OBV). After the reaction high forms the second neckline point, the right shoulder's decline should be accompanied with light volume. It is normal to experience profit-taking after an advance. Volume analysis helps distinguish between normal profit-taking and heavy selling pressure. With light volume on the pullback, indicators like CMF and OBV should remain strong. The most important moment for volume occurs on the advance from the low of the right shoulder. For a breakout to be considered valid, there needs to be an expansion of volume on the advance and during the breakout. 7. Neckline Break: The head and shoulders pattern is not complete and the downtrend is not reversed until neckline resistance is broken. For a head and shoulders bottom, this must occur in a convincing manner with an expansion of volume. 8. Resistance turned support: Once resistance is broken, it is common for this same resistance level to turn into support. Often, the price will return to the resistance break and offer a second chance to buy. 9. Price Target: After breaking neckline resistance, the projected advance is found by measuring the distance from the neckline to the bottom of the head. This distance is then added to the neckline to reach a price target. Any price target should serve as a rough guide and other factors should be considered as well. These factors might include previous resistance levels, Fibonacci retracements or long-term moving averages. Alaska Air (ALK) formed a head and shoulders bottom with a downward sloping neckline. Key points include:

http://www.stockcharts.com/education/What/ChartAnalysis/headShouldersBottom-print.html (3 of 7) [2/18/2003 5:16:53 AM]

StockCharts.com - Head and Shoulders Bottom (Reversal)

1. The stock began a downtrend in early July and declined from 60 to 26. 2. The low of the left shoulder formed with a large spike in volume on a sharp down day (red arrows). 3. The reaction rally at around 42 1/2 formed the first point of the neckline (1). Volume on the advance was respectable with many gray bars exceeding the 60day SMA. (Note: gray bars denote advancing days, black bars declining days and the thin red horizontal is the 60-day SMA). 4. The decline from 42 1/2 to 26 (head) was quite dramatic, but volume did not get out of hand. Chaikin Money Flow was mostly positive when the lows around 26 were forming. 5. The advance off of the low saw a large expansion of volume (green oval) and gap up. The strength behind the move indicated that a significant low formed. 6. After the reaction high around 39, the second point of the neckline could be http://www.stockcharts.com/education/What/ChartAnalysis/headShouldersBottom-print.html (4 of 7) [2/18/2003 5:16:53 AM]

StockCharts.com - Head and Shoulders Bottom (Reversal)

drawn (2). 7. The decline from 39 to 33 occurred on light volume until the final two days, when volume reached its highest point in a month. Even though there are two long black (down) volume bars, these are surrounded by above-average gray (up) volume bars. Also notice how trendline resistance near 35 became support around 33 on the price chart. 8. The advance off of the low of the right shoulder occurred with above average volume. Chaikin Money Flow was at its highest levels and surpassed +20% shortly after neckline resistance was broken. 9. After breaking neckline resistance, the stock returned to this newfound support with a successful test around 35 (green arrow). AT&T (T) formed a head and shoulders bottom with a flat neckline. The shoulders are a bit shallow, but the neckline and head are well pronounced. Key points include:

http://www.stockcharts.com/education/What/ChartAnalysis/headShouldersBottom-print.html (5 of 7) [2/18/2003 5:16:53 AM]

StockCharts.com - Head and Shoulders Bottom (Reversal)

1. The stock established a 6-month downtrend with the trendline extending down from Mar-98. 2. After a head fake above the trendline in late June, the stock fell from 43 11/16 to 34 11/16 with a sharp increase in volume to form the left shoulder. 3. The rally to 40 13/16 met resistance from the trendline and the reaction high became the first point of the neckline. 4. The decline from 40 13/16 to 33 7/16 finished with a piercing pattern to form the low of the head. Even though volume was heavy when the long black candlestick formed, the subsequent reversal occurred on even higher volume. This reversal was followed with a number of strong advances and up gaps. Also notice that Chaikin Money Flow was above +10% when the low of the head formed. 5. The advance from the low of the head broke above the trendline extending down from Mar-98 and met resistance around 41. This reaction high formed the second point of the neckline. 6. The right shoulder was quite short and shallow. The low was recorded at 37 7/16 and Chaikin Money Flow remained above +10% the whole time. Support was found from the trendline that offered resistance a few weeks earlier. 7. The stock advanced sharply off of lows that formed the right shoulder and volume increased three straight days (blue arrow). This is a bit early, but volume remained just above average for the neckline breakout a few days later. Also Chaikin Money Flow remained above +10% the whole time. 8. After the break of neckline resistance, the stock tested this newfound support twice while consolidating recent gains. The power arrived a few weeks later with a strong move off support and a huge increase in volume. The stock subsequently advanced from the low forties to the low sixties. Head and shoulder bottoms are one of the most common and reliable reversal formations. It is important to remember that they occur after a downtrend and usually mark a major trend reversal when complete. While it is preferable that the left and right shoulders be symmetrical, it is not an absolute requirement. Shoulders can be different widths as well as different heights. Keep in mind that technical analysis is more an art than a science. If you are looking for the perfect pattern, it may be a long time coming. Analysis of the head and shoulders bottom should focus on correct identification of neckline resistance and volume patterns. These are two of the most important aspects to a successful read, and by extension a successful trade. The neckline resistance breakout combined with an increase in volume indicates an increase in demand at higher prices. Buyers are exerting greater force and the price is being affected. As seen from the examples, traders do not always have to chase a stock after the neckline breakout. Many times, but certainly not always, the price will return to this new support level and offer a second chance to buy. Measuring the expected length of the advance after the breakout can be helpful, but don't count on it for your ultimate target. As the pattern unfolds over time, other aspects of the technical picture are likely to take http://www.stockcharts.com/education/What/ChartAnalysis/headShouldersBottom-print.html (6 of 7) [2/18/2003 5:16:53 AM]

StockCharts.com - Head and Shoulders Bottom (Reversal)

precedent. Technical analysis is dynamic and your analysis should incorporate aspects of the long, medium and short term picture.

Written by Arthur Hill Send us your Feedback!

©2002 StockCharts.com All Rights Reserved Terms of Use

http://www.stockcharts.com/education/What/ChartAnalysis/headShouldersBottom-print.html (7 of 7) [2/18/2003 5:16:53 AM]

StockCharts.com - Falling Wedge (Reversal)

Falling Wedge (Reversal) The falling wedge is a bullish pattern that begins wide at the top and contracts as prices move lower. This price action forms a cone that slopes down as the reaction highs and reaction lows converge. In contrast to symmetrical triangles, which have no definitive slope and no bias, falling wedges definitely slope down and have a bullish bias. However, this bullish bias cannot be realized until a resistance breakout. The falling wedge can also fit into the continuation category. As a continuation pattern, the falling wedge will still slope down, but the slope will be against the prevailing uptrend. As a reversal pattern, the falling wedge slopes down and with the prevailing trend. Regardless of the type (reversal or continuation), falling wedges are regarded as bullish patterns.

http://www.stockcharts.com/education/What/ChartAnalysis/fallingWedge-print.html (1 of 5) [2/18/2003 5:17:07 AM]

StockCharts.com - Falling Wedge (Reversal)

1. Prior Trend: To qualify as a reversal pattern, there must be a prior trend to reverse. Ideally, the falling wedge will form after an extended downtrend and mark the final low. The pattern usually forms over a 3-6 month period and the preceding downtrend should be at least 3 months old. 2. Upper resistance line: It takes at least two reaction highs to form the upper resistance line, ideally three. Each reaction high should be lower than the previous highs. 3. Lower support line: At least two reaction lows are required to form the lower support line. Each reaction low should be lower than the previous lows. 4. Contraction: The upper resistance line and lower support line converge to form a cone as the pattern matures. The reaction lows still penetrate the previous lows, but this penetration becomes shallower. Shallower lows indicate a decrease in selling pressure and create a lower support line with less negative slope than the http://www.stockcharts.com/education/What/ChartAnalysis/fallingWedge-print.html (2 of 5) [2/18/2003 5:17:07 AM]

StockCharts.com - Falling Wedge (Reversal)

upper resistance line. 5. Resistance Break: Bullish confirmation of the pattern does not come until the resistance line is broken in convincing fashion. It is sometimes prudent to wait for a break above the previous reaction high for further confirmation. Once resistance is broken, there can sometimes be a correction to test the newfound support level. 6. Volume: While volume is not particularly important on rising wedges, it is an essential ingredient to confirm a falling wedge breakout. Without an expansion of volume, the breakout will lack conviction and be vulnerable to failure. As with the rising wedge, the falling wedge can be one of the most difficult chart patterns to accurately recognize and trade. When lower highs and lower lows form, as in a falling wedge, a security remains in a downtrend. The falling wedge is designed to spot a decrease in downside momentum and alert technicians to a potential trend reversal. Even though selling pressure may be diminishing, demand does not win out until resistance is broken. As with most patterns, it is important to wait for a breakout and combine other aspects of technical analysis to confirm signals.

http://www.stockcharts.com/education/What/ChartAnalysis/fallingWedge-print.html (3 of 5) [2/18/2003 5:17:07 AM]

StockCharts.com - Falling Wedge (Reversal)

FCX provides a textbook example of a falling wedge at the end of a long downtrend. ●

●

●

●

Prior Trend: The downtrend for FCX began in the third quarter of 1997. There was a brief advance in Mar-98, but the downtrend resumed and the stock was trading at new lows by Feb-99. Upper resistance line: The upper resistance line formed with four successively lower peaks. Lower support line: The lower support line formed with four successive lower lows. Contraction: The upper resistance line and lower support line converged as the pattern matured. Even though each low is lower than the previous low, these lows are only slightly lower. The shallowness of the new lows indicates that demand is stepping almost immediately after a new low is recorded. The supply overhang

http://www.stockcharts.com/education/What/ChartAnalysis/fallingWedge-print.html (4 of 5) [2/18/2003 5:17:07 AM]

StockCharts.com - Falling Wedge (Reversal)

●

●

●

remains, but slope of the upper resistance line is more negative than the lower support line. Resistance break: In contrast to the three previous lows, the late February low was flat and consolidated just above 9 for a few weeks. The subsequent breakout in March occurred with a series of strong advances. In addition, there was a positive divergence in the PPO. Volume: After the large volume decline on 24-Feb (red arrow), upside volume began to increase. Above-average volume continued on advancing days and when the stock broke trendline resistance. Money flows confirmed the strength by surpassing their Nov-98 high and moving to their highest level since Apr-98. After the trendline breakout, there was a brief pullback to support from the trendline extension. The stock consolidated for a few weeks and then advanced further on increased volume again.

Written by Arthur Hill Send us your Feedback!

©2002 StockCharts.com All Rights Reserved Terms of Use

http://www.stockcharts.com/education/What/ChartAnalysis/fallingWedge-print.html (5 of 5) [2/18/2003 5:17:07 AM]

StockCharts.com - Rising Wedge (Reversal pattern)

Rising Wedge (Reversal pattern) The rising wedge is a bearish pattern that begins wide at the bottom and contracts as prices move higher and the trading range narrows. In contrast to symmetrical triangles, which have no definitive slope and no bullish or bearish bias, rising wedges definitely slope up and have a bearish bias. Even though this article will focus on the rising wedge as a reversal pattern, the pattern can also fit into the continuation category. As a continuation pattern, the rising wedge will still slope up, but the slope will be against the prevailing downtrend. As a reversal pattern, the rising wedge will slope up and with the prevailing trend. Regardless of the type (reversal or continuation), rising wedges are bearish.

http://www.stockcharts.com/education/What/ChartAnalysis/risingWedge-print.html (1 of 4) [2/18/2003 5:17:17 AM]

StockCharts.com - Rising Wedge (Reversal pattern)

1. Prior Trend: In order to qualify as a reversal pattern, there must be a prior trend to reverse. The rising wedge usually forms over a 3-6 month period and can mark an intermediate or long-term trend reversal. Sometimes the current trend is totally contained within the rising wedge; other times the pattern will form after an extended advance. 2. Upper resistance line: It takes at least two reaction highs to form the upper resistance line, ideally three. Each reaction high should be higher than the previous high. 3. Lower support line: At least two reaction lows are required to form the lower support line. Each reaction low should be higher than the previous low. 4. Contraction: The upper resistance line and lower support line converge as the pattern matures. The advances from the reaction lows (lower support line) become shorter and shorter, which makes the rallies unconvincing. This creates http://www.stockcharts.com/education/What/ChartAnalysis/risingWedge-print.html (2 of 4) [2/18/2003 5:17:17 AM]

StockCharts.com - Rising Wedge (Reversal pattern)

an upper resistance line that fails to keep pace with the slope of the lower support line and indicates a supply overhang as prices increase. 5. Support break: Bearish confirmation of the pattern does not come until the support line is broken in a convincing fashion. It is sometimes prudent to wait for a break of the previous reaction low. Once support is broken, there can sometimes be a reaction rally to test the newfound resistance level. 6. Volume: Ideally, volume will decline as prices rise and the wedge evolves. An expansion of volume on the support line break can taken as bearish confirmation. The rising wedge can be one of the most difficult chart patterns to accurately recognize and trade. While it is a consolidation formation, the loss of upside momentum on each successive high gives the pattern its bearish bias. However, the series of higher highs and higher lows keeps the trend inherently bullish. The final break of support indicates that the forces of supply have finally won out and lower prices are likely. There are no measuring techniques to estimate the decline -- other aspects of technical analysis should be employed to forecast price targets.

http://www.stockcharts.com/education/What/ChartAnalysis/risingWedge-print.html (3 of 4) [2/18/2003 5:17:17 AM]

StockCharts.com - Rising Wedge (Reversal pattern)

ANN provides a good example of the rising wedge as a reversal pattern that forms in the face of weakening momentum and money flow. ●

●

●

●

●

●

●

Prior Trend: From a low around 20 in Oct-98, ANN surpassed 50 in less than 7 months. The final leg up was a sharp advance from below 35 in Feb to 53.06 in mid-April. Upper resistance line: The upper resistance line formed with three successively higher peaks. Lower support line: The lower support line formed with three successive higher lows. Contraction: The upper resistance line and lower support line converged as the pattern matured. A visual assessment confirms that the slope of the lower support line is steeper than that of the upper resistance line. Less slope in the upper resistance line indicates that momentum is waning as the stock makes new highs. Support break: The stock hugged the support line for over a week before finally breaking with a sharp decline. The previous reaction low was broken a few days later with long black candlestick (red arrow). Volume: Chaikin Money Flow turned negative in late April and was well below 10% when the support line was broken. There was an expansion of volume when the previous reaction low was broken. Support from the April reaction low around 46 turned into resistance and the stock tested this level in early July before declining further.

Written by Arthur Hill Send us your Feedback!

©2002 StockCharts.com All Rights Reserved Terms of Use

http://www.stockcharts.com/education/What/ChartAnalysis/risingWedge-print.html (4 of 4) [2/18/2003 5:17:17 AM]

StockCharts.com - Rounding Bottom (Reversal)

Rounding Bottom (Reversal) The rounding bottom is a long-term reversal pattern that is best suited for weekly charts. It is also referred to as a saucer bottom, and represents a long consolidation period that turns from a bearish bias to a bullish bias.

1. Prior Trend: In order to be a reversal pattern, there must be a prior trend to http://www.stockcharts.com/education/What/ChartAnalysis/roundingBottom-print.html (1 of 4) [2/18/2003 5:17:27 AM]

StockCharts.com - Rounding Bottom (Reversal)

2.

3.

4. 5.

6.

reverse. Ideally, the low of a rounding bottom will mark a new low or reaction low. In practice, there are occasions when the low is recorded many months earlier and the security trades flat before forming the pattern. When the rounding bottom does finally form, its low may not be the lowest low of the last few months. Decline: The first portion of the rounding bottom is the decline that leads to the low of the pattern. This decline can take on different forms: some are quite jagged with a number of reaction highs and lows, while others trade lower in a more linear fashion. Low: The low of the rounding bottom can resemble a "V' bottom, but should not be too sharp and should take a few weeks to form. Because prices are in a longterm decline, the possibility of a selling climax exists that could create a lower spike. Advance: The advance off of the lows forms the right half of the pattern and should take about the same amount of time as the prior decline. If the advance is too sharp, then the validity of a rounding bottom may be in question. Breakout: Bullish confirmation comes when the pattern breaks above the reaction high that marked the beginning of the decline at the start of the pattern. As with most resistance breakouts, this level can become support. However, rounding bottoms represent long-term reversal and this new support level may not be that significant. Volume: In an ideal pattern, volume levels will track the shape of the rounding bottom: high at the beginning of the decline, low at the end of the decline and rising during the advance. Volume levels are not too important on the decline, but there should be an increase in volume on the advance and preferably on the breakout.

A rounding bottom could be thought of as a head and shoulders bottom without readily identifiable shoulders. The head represents the low and is fairly central to the pattern. The volume patterns are similar and confirmation comes with a resistance breakout. While symmetry is preferable on the rounding bottom, the left and right side do not have to be equal in time or slope. The important thing is to capture the essence of the pattern.

http://www.stockcharts.com/education/What/ChartAnalysis/roundingBottom-print.html (2 of 4) [2/18/2003 5:17:27 AM]

StockCharts.com - Rounding Bottom (Reversal)

AMGN provides an example of a rounding bottom that formed after a long consolidation period. Throughout 1996, the stock traded in a tight range bound by 16.63 and 12.83. The trading range continued the first half of 1997 and the stock broke support by falling to a low of 12 in August. ●

●

●

Prior Trend: With the break of support at 12.83, it appeared that a downtrend had begun. Even though the decline was not that sharp, the new reaction low represented a 52-week low. AMGN was clearly not in an uptrend. Decline: The stock declined from 17 to a low of 11.22 and a pair of hammers formed in Oct-98 to mark the end of the decline (red arrow). Low: Prior to the hammers, the stock traded around 12 for the previous 6 weeks. When the gap up with high volume followed the hammers, it appeared that a low had been formed. After a short rally, there was another test of the low and a

http://www.stockcharts.com/education/What/ChartAnalysis/roundingBottom-print.html (3 of 4) [2/18/2003 5:17:27 AM]

StockCharts.com - Rounding Bottom (Reversal)

●

●

●

higher low formed at 11.66. Advance: From the second low at 11.66, the advance began in earnest and volume started to increase. In March, there was a large advance with the highest volume in 4 months (green arrow). May-97 resistance at 17 represented the confirmation line for the pattern. The stock broke resistance in Jul-98 with a further expansion of volume. This breakout was also confirmed with a new high in OBV. After breaking resistance, there was a test of support and the stock actually fell back below 17. The stock had advanced from 11.66 to 19.84 in 6 months and some sort of pullback could have been expected.

Written by Arthur Hill Send us your Feedback!

©2002 StockCharts.com All Rights Reserved Terms of Use

http://www.stockcharts.com/education/What/ChartAnalysis/roundingBottom-print.html (4 of 4) [2/18/2003 5:17:27 AM]

StockCharts.com - Triple Top (Reversal)

Triple Top (Reversal) The triple top is a reversal pattern made up of three equal highs followed by a break below support. In contrast to the triple bottom, triple tops usually form over a shorter time frame and typically range from 3 to 6 months. Generally speaking, bottoms take longer to form than tops. We will first examine the individual parts of the pattern and then look at an example.

1. Prior Trend: With any reversal pattern, there should be an existing trend to reverse. In the case of the triple top, an uptrend or long trading range should be in place. Sometimes there will be a definitive uptrend to reverse. Other times the uptrend will fade and become many months of sideways trading. 2. Three Highs: All three highs should be reasonable equal, well spaced and mark

http://www.stockcharts.com/education/What/ChartAnalysis/tripleTop-print.html (1 of 4) [2/18/2003 5:17:41 AM]

StockCharts.com - Triple Top (Reversal)

3.

4. 5.

6.

significant turning points. The highs do not have to be exactly equal, but should be reasonably equivalent to each other. Volume: As the triple top develops, overall volume levels usually decline. Volume sometimes increases near the highs. After the third high, an expansion of volume on the subsequent decline and at the support break greatly reinforces the soundness of the pattern. Support break: As with many other reversal patterns, the triple top is not complete until a support break. The lowest point of the formation, which would be the lowest of the intermittent lows, marks this key support level. Support turns resistance: Broken support becomes potential resistance, and there is sometimes a test of this newfound resistance level with a subsequent reaction rally. Price Target: The distance from the support break to highs can be measured and subtracted from the support break for a price target. The longer the pattern develops, the more significant is the ultimate break. Triple tops that are 6 or more months old represent major tops and a price target is less likely to be effective.

Throughout the development of the triple top, it can start to resemble a number of patterns. Before the third high forms, the pattern may look like a double top. Three equal highs can also be found in an ascending triangle or rectangle. Of these patterns mentioned, only the ascending triangle has bullish overtones; the others are neutral until a break occurs. In this same vein, the triple top should also be treated as a neutral pattern until a breakout occurs. The inability to break above resistance is bearish, but the bears have not won the battle until support is broken. Volume on the last decline off resistance can sometimes yield a clue. If there is a sharp increase in volume and momentum, then the chances of a support break increase.

http://www.stockcharts.com/education/What/ChartAnalysis/tripleTop-print.html (2 of 4) [2/18/2003 5:17:41 AM]

StockCharts.com - Triple Top (Reversal)

When looking for patterns, it is important to keep in mind that technical analysis is more art and less science. Pattern interpretations should be fairly specific, but not overly exacting as to obstruct the spirit of the pattern. A pattern may not fit the description to the letter, but that should not detract from its robustness. For example: it can be difficult to find a triple top with three highs that are exactly equal. However, if the highs are within reasonable proximity and other aspects of the technical analysis picture jibe, it would embody the spirit of a triple top. The spirit is three attempts at resistance, followed by a breakdown below support, with volume confirmation. ROK illustrates an example of a triple top that does not fit exactly, but captures the spirit of the pattern. ●

The stock was in an uptrend and remained above the trendline extending up from Oct-98 until the break in late August 1999.

http://www.stockcharts.com/education/What/ChartAnalysis/tripleTop-print.html (3 of 4) [2/18/2003 5:17:41 AM]

StockCharts.com - Triple Top (Reversal) ●

●

●

●

●

Over a period of about 4 months, the stock bounced off resistance around 64. The first attempt happened in May, the second in July and the third in August. The third attempt was the most feeble and fell short of the resistance line by 1.19 points or about 1.8%. The decline from the third high broke trendline support and the stock continued to fall past support from the previous lows. Triple top support should be drawn from the lowest low of the pattern, which would be the May low around 54.50. Volume expanded after the stock broke trendline support. The stock paused for a few days when support at 54.50 was reached, but volume accelerated when this support level was broken (grey dotted line). In addition, Chaikin Money Flow turned negative and broke below -10%. After the support break, there was a test of the newfound resistance a few weeks later. Money flows continued to indicate selling pressure and volume expanded when the stock began to fall again. The projected decline was 9 points and the stock reached this target soon after the resistance test.

Written by Arthur Hill Send us your Feedback!

©2002 StockCharts.com All Rights Reserved Terms of Use

http://www.stockcharts.com/education/What/ChartAnalysis/tripleTop-print.html (4 of 4) [2/18/2003 5:17:41 AM]

StockCharts.com - Triple Bottom (Reversal)

Triple Bottom (Reversal) The triple bottom is a reversal pattern made up of three equal lows followed by a breakout above resistance. While this pattern can form over just a few months, it is usually a long-term pattern that covers many months. Because of its long-term nature, weekly charts can be best suited for analysis. We will first examine the individual parts of the pattern and then look at an example.

http://www.stockcharts.com/education/What/ChartAnalysis/triplebottom-print.html (1 of 4) [2/18/2003 5:17:52 AM]

StockCharts.com - Triple Bottom (Reversal)

1. Prior Trend: With any reversal pattern, there should be an existing trend to reverse. In the case of the triple bottom, a downtrend or long trading range should be in place. Sometimes there will be a definitive downtrend to reverse. Other times the downtrend will fade away after many months of sideways trading. 2. Three lows: All three lows should be reasonable equal, well spaced and mark significant turning points. The lows do not have to be exactly equal, but should be reasonably equivalent. 3. Volume: As the triple bottom develops, overall volume levels usually decline. Volume sometimes increases near the lows. After the third low, an expansion of volume on the advance and at the resistance breakout greatly reinforces the soundness of the pattern. 4. Resistance break: As with many other reversal patterns, the triple bottom is not complete until a resistance breakout. The highest point of the formation, which would be the highest of the intermittent highs, marks resistance. 5. Resistance turns support: Broken resistance becomes potential support, and there is sometimes a test of this newfound support level with the first correction. Because the triple bottom is a long-term pattern, the test of newfound support may occur many months later. 6. Price Target: The distance from the resistance breakout to lows can be measured and added to the resistance break for a price target. The longer the pattern develops, the more significant is the ultimate breakout. Triple bottoms that are 6 or more months in duration represent major bottoms and a price target is less likely to be effective. As the triple bottom develops, it can start to resemble a number of patterns. Before the third low forms, the pattern may look like a double bottom. Three equal lows can also be found in a descending triangle or rectangle. Of these patterns mentioned, only the descending triangle has bearish overtones; the others are neutral until a breakout occurs. Similarly, the triple bottom should also be treated as a neutral pattern until a breakout occurs. The ability to hold support is bullish, but demand has not won the battle until resistance is broken. Volume on the last advance can sometimes yield a clue. If there is a sharp increase in volume and momentum, then the chances of a breakout increase.

http://www.stockcharts.com/education/What/ChartAnalysis/triplebottom-print.html (2 of 4) [2/18/2003 5:17:52 AM]

StockCharts.com - Triple Bottom (Reversal)

After a failed double bottom breakout, ANDW formed a large triple bottom. While the new reaction high (black arrow) and potential double bottom breakout seemed bullish, the stock subsequently fell back to support. ●

●

●

Technically, the downtrend ended when the stock formed a higher low in Mar-99 and surpassed its Jan-99 high by closing above 20 in Jul-99 (black arrow). Even though the downtrend ended, it would have been difficult to label the trend bullish after the third test of support around 11. Over a 13-month timeframe, three relatively equal lows formed in Oct-98, Mar-99 and Nov-99. When the Jul-00 high surpassed the Jan-99 high, the possibility of a rectangle pattern was ruled out. Resistance at 22 1/2 was broken in Jan-00. The stock closed above this key level for 5 consecutive weeks to confirm the breakout.

http://www.stockcharts.com/education/What/ChartAnalysis/triplebottom-print.html (3 of 4) [2/18/2003 5:17:52 AM]

StockCharts.com - Triple Bottom (Reversal) ●

●

●

Even though volume expanded near the second and third lows, the 10-day EMA of volume declined between the lows. The advance off the third low saw a dramatic expansion of volume that lasted many weeks. The Accumulation/Distribution Line formed a positive divergence in 1999 and broke to new highs with the stock in Jan00. After the resistance break, the stock fell below 22 1/2 twice over the next 2 months. Based on the Feb-00 and Apr-00 lows, a new support level was established at 20 and. Because upside movement was limited after the breakout (a high of 25 1/2), a pullback below 22 1/2 might have been expected. Based on Oct-99 resistance, critical support could have been marked at 18 1/2. ANDW built a base over a 13-month period. Even though the height of the pattern is relatively impressive, it pales in comparison to the length of the base. The length of this pattern and subsequent breakout suggest a long-term change of sentiment.

Written by Arthur Hill Send us your Feedback!

©2002 StockCharts.com All Rights Reserved Terms of Use

http://www.stockcharts.com/education/What/ChartAnalysis/triplebottom-print.html (4 of 4) [2/18/2003 5:17:52 AM]

StockCharts.com - Cup with Handle (Continuation)

Cup with Handle (Continuation) The Cup with Handle is a bullish continuation pattern that marks a consolidation period followed by a breakout. It was developed by William O'Neil and introduced in his 1988 book, How to Make Money in Stocks. As its name implies, there are two parts to the pattern: the cup and the handle. The cup forms after an advance and looks like a bowl or rounding bottom. As the cup is completed, a trading range develops on the right hand side and the handle is formed. A subsequent breakout from the handle's trading range signals a continuation of the prior advance.

http://www.stockcharts.com/education/What/ChartAnalysis/cuphandle-print.html (1 of 5) [2/18/2003 5:18:04 AM]

StockCharts.com - Cup with Handle (Continuation)

1. Trend: To qualify as a continuation pattern, a prior trend should exist. Ideally, the trend should be a few months old and not too mature. The more mature the trend, the less chance that the pattern marks a continuation or the less upside potential. 2. Cup: The cup should be "U" shaped and resemble a bowl or rounding bottom. A "V" shaped bottom would be considered too sharp of a reversal to qualify. The softer "U" shape ensures that the cup is a consolidation pattern with valid support at the bottom of the "U". The perfect pattern would have equal highs on both sides of the cup, but this is not always the case. 3. Cup Depth: Ideally, the depth of the cup should retrace 1/3 or less of the previous advance. However, with volatile markets and over-reactions, the retracement could range from 1/3 to 1/2. In extreme situations, the maximum retracement could be 2/3, which is conforms with Dow Theory. http://www.stockcharts.com/education/What/ChartAnalysis/cuphandle-print.html (2 of 5) [2/18/2003 5:18:04 AM]

StockCharts.com - Cup with Handle (Continuation)

4. Handle: After the high forms on the right side of the cup, there is a pullback that forms the handle. Sometimes this handle resembles a flag or pennant that slopes downward, other times just a short pullback. The handle represents the final consolidation/pullback before the big breakout and can retrace up to 1/3 of the cup's advance, but usually not more. The smaller the retracement is, the more bullish the formation and significant the breakout. Sometimes it is prudent to wait for a break above the resistance line established by the highs of the cup. 5. Duration: The cup can extend from 1 to 6 months, sometimes longer on weekly charts. The handle can be from 1 week to many weeks and ideally completes within 1-4 weeks. 6. Volume: There should be a substantial increase in volume on the breakout above the handle's resistance. 7. Target: The projected advance after breakout can be estimated by measuring the distance from the right peak of the cup to the bottom of the cup. As with most chart patterns, it is more important to capture the essence of the pattern than the particulars. The cup is a bowl-shaped consolidation and the handle is a short pullback followed by a breakout with expanding volume. A cup retracement of 62% may not fit the pattern requirements, but a particular stock's pattern may still capture the essence of the Cup with Handle.

http://www.stockcharts.com/education/What/ChartAnalysis/cuphandle-print.html (3 of 5) [2/18/2003 5:18:04 AM]

StockCharts.com - Cup with Handle (Continuation)

●

●

●

●

Trend: EMC established the bull trend by advancing from 10 and change to above 30 in about 5 months. The stock peaked in March and then began to pull back and consolidate its large gains. Cup: The April decline was quite sharp, but the lows extended over a two month period to form the bowl that marked a consolidation period. Also note that support was found from the Feb-99 lows. Cup Depth: The low of the cup retraced 42% of the previous advance. After an advance in June and July, the stock peaked at 32.69 to complete the cup (red arrow). Handle: Another consolidation period began in July to start the handle formation. There was a sharp decline in August that caused the handle to retrace more than 1/3 of the cup's advance. However, there was a quick recovery and the stock traded back up within the normal handle boundaries within a week. I believe the essence of the formation remained valid after this sharp decline.

http://www.stockcharts.com/education/What/ChartAnalysis/cuphandle-print.html (4 of 5) [2/18/2003 5:18:04 AM]

StockCharts.com - Cup with Handle (Continuation) ●

●

●

Duration: The cup extended for about 3 months and the handle for about 1 1/2 months. Volume: In early Sept-00, the stock broke handle resistance with a gap up and volume expansion (green arrow). In addition, Chaikin Money Flow soared above +20%. Target: The projected advance after breakout was estimated at 9 points from the breakout around 32. EMC easily fulfilled this target over the next few months.

Written by Arthur Hill Send us your Feedback!

©2002 StockCharts.com All Rights Reserved Terms of Use

http://www.stockcharts.com/education/What/ChartAnalysis/cuphandle-print.html (5 of 5) [2/18/2003 5:18:04 AM]

StockCharts.com - Flag, Pennant (Continuation)

Flag, Pennant (Continuation) Flags and Pennants are short-term continuation patterns that mark a small consolidation before the previous move resumes. These patterns are usually preceded by a sharp advance or decline with heavy volume, and mark a mid-point of the move.

1. Sharp Move: To be considered a continuation pattern, there should be evidence http://www.stockcharts.com/education/What/ChartAnalysis/flagPennant-print.html (1 of 4) [2/18/2003 5:18:16 AM]

StockCharts.com - Flag, Pennant (Continuation)

2.

3.

4.

5.

6. 7.

8.

of a prior trend. Flags and pennants require evidence of a sharp advance or decline on heavy volume. These moves usually occur on heavy volume and can contain gaps. This move usually represents the first leg of a significant advance or decline and the flag/pennant is merely a pause. Flagpole: The flagpole is the distance from the first resistance or support break to the high or low of the flag/pennant. The sharp advance (or decline) that forms the flagpole should break a trendline or resistance/support level. A line extending up from this break to the high of the flag/pennant forms the flagpole. Flag: A flag is a small rectangle pattern that slopes against the previous trend. If the previous move was up, then the flag would slope down. If the move was down, then the flag would slope up. Because flags are usually too short in duration to actually have reaction highs and lows, the price action just needs to be contained within two parallel trendlines. Pennant: A pennant is a small symmetrical triangle that begins wide and converges as the pattern matures (like a cone). The slope is usually neutral. Sometimes there will not be specific reaction highs and lows from which to draw the trendlines and the price action should just be contained within the converging trendlines. Duration: Flags and pennants are short-term patterns that can last from 1 to 12 weeks. There is some debate on the timeframe and some consider 8 weeks to be pushing the limits for a reliable pattern. Ideally, these patterns will form between 1 and 4 weeks. Once a flag becomes more than 12 weeks old, it would be classified as a rectangle. A pennant more than 12 weeks old would turn into a symmetrical triangle. The reliability of patterns that fall between 8 and 12 weeks is debatable. Break: For a bullish flag or pennant, a break above resistance signals that the previous advance has resumed. For a bearish flag or pennant, a break below support signals that the previous decline has resumed. Volume: Volume should be heavy during the advance or decline that forms the flagpole. Heavy volume provides legitimacy for the sudden and sharp move that creates the flagpole. An expansion of volume on the resistance (support) break lends credence to the validity of the formation and the likelihood of continuation. Targets: The length of the flagpole can be applied to the resistance break or support break of the flag/pennant to estimate the advance or decline.

Even though flags and pennants are common formations, identification guidelines should not be taken lightly. It is important that flags and pennants are preceded by a sharp advance or decline. Without a sharp move, the reliability of the formation becomes questionable and trading could carry added risk. Look for volume confirmation on the initial move, consolidation and resumption to augment the robustness of pattern identification.

http://www.stockcharts.com/education/What/ChartAnalysis/flagPennant-print.html (2 of 4) [2/18/2003 5:18:16 AM]

StockCharts.com - Flag, Pennant (Continuation)

HWP provides an example of a flag that forms after a sharp and sudden advance. ●

●

● ●

●

Sharp move: After consolidating for three months, HWP broke above resistance at 56 to begin a sharp advance. The 5-April high and 16-Feb trendline marked resistance and the breakout occurred with a volume expansion. The stock advanced from 56 to 76 in a mere 4 weeks. (Note: It is also possible that a small pennant formed in early May with resistance around 62.25). Flagpole: The distance from the breakout at 56 to the flag's high at 76 formed the flagpole. Flag: Price action was contained within two parallel trendlines that sloped down. Duration: From a high at 76 to the breakout at 72.25, the flag formed over a 23day period. Breakout: The first break above the flag's upper trendline occurred on 21-June

http://www.stockcharts.com/education/What/ChartAnalysis/flagPennant-print.html (3 of 4) [2/18/2003 5:18:16 AM]

StockCharts.com - Flag, Pennant (Continuation)

●

●

without an expansion of volume. However, the stock gapped up a week later and closed strong with above-average volume (red arrows) Volume: To recap -- volume expanded on the sharp advance to form the flagpole, contracted during the flag's formation and expanded right after the resistance breakout. Targets: The length of the flagpole measured 20 points and was applied to the resistance breakout at 72.25 to project a target of 92.25.

Written by Arthur Hill Send us your Feedback!

©2002 StockCharts.com All Rights Reserved Terms of Use

http://www.stockcharts.com/education/What/ChartAnalysis/flagPennant-print.html (4 of 4) [2/18/2003 5:18:16 AM]

StockCharts.com - Symmetrical Triangle (Continuation)

Symmetrical Triangle (Continuation) The symmetrical triangle, which can also be referred to as a coil, usually forms during a trend as a continuation pattern. The pattern contains at least two lower highs and two higher lows. When these points are connected, the lines converge as they are extended and the symmetrical triangle takes shape. You could also think of it as a contracting wedge, wide at the beginning and narrowing over time.

While there are instances when symmetrical triangles mark important trend reversals, they more often mark a continuation of the current trend. Regardless of the nature of the pattern, continuation or reversal, the direction of the next major move can only be determined after a valid breakout. We will examine each part of the symmetrical triangle individually and then provide an example with Consesco.

http://www.stockcharts.com/education/What/ChartAnalysis/symmTriangle-print.html (1 of 4) [2/18/2003 5:18:27 AM]

StockCharts.com - Symmetrical Triangle (Continuation)

1. Trend: In order to qualify as a continuation pattern, an established trend should exist. The trend should be at least a few months old and the symmetrical triangle marks a consolidation period before continuing after the breakout. 2. 4 points: At least 2 points are required to form a trendline and two trendlines are required to form a symmetrical triangle. Therefore, a minimum of 4 points are required to begin considering a formation as a symmetrical triangle. The second high (4) should be lower than the first (2) and the upper line should slope down. The second low (3) should be higher than the first (1) and the lower line should slope up. Ideally, the pattern will form with 6 points (3 on each side) before a breakout occurs. 3. Volume: As the symmetrical triangle extends and the trading range contracts, volume should start to diminish. This refers to the quiet before the storm, or the tightening consolidation before the breakout. 4. Duration: The symmetrical triangle can extend for a few weeks or many months. If the pattern is less than 3 weeks, it is usually considered a pennant. Typically, the time duration is about 3 months. 5. Breakout Timeframe: The ideal breakout point occurs 1/2 to 3/4 of the way through the pattern's development or time-span. The time-span of the pattern can be measured from the apex (convergence of upper and lower lines) back to the beginning of the lower trendline (base). A break before the 1/2 way point might be premature and a break too close to the apex may be insignificant. After all, as the apex approaches, a breakout must occur sometime. 6. Breakout Direction: The future direction of the breakout can only be determined after the break has occurred. Sound obvious enough, but attempting to guess the direction of the breakout can be dangerous. Even though a continuation pattern is supposed to breakout in the direction of the long-term trend, this is not always the case. 7. Breakout Confirmation: For a break to be considered valid, it should be on a closing basis. Some traders apply a price (3% break) or time (sustained for 3 days) filter to confirm validity. The breakout should occur with an expansion in volume, especially on upside breakouts. 8. Return to Apex: After the breakout (up or down), the apex can turn into future support or resistance. The price sometimes returns to the apex or a support/resistance level around the breakout before resuming in the direction of the breakout. 9. Price Target: There are two methods to estimate the extent of the move after the breakout. First, the widest distance of the symmetrical triangle can be measured and applied to the breakout point. Second, a trendline can be drawn parallel to the pattern's trendline that slopes (up or down) in the direction of the break. The extension of this line will mark a potential breakout target. Edwards and Magee suggest that roughly 75% of symmetrical triangles are continuation patterns and the rest mark reversals. The reversal patterns can be especially difficult to analyze and often have false breakouts. Even so, we should not anticipate the direction of the breakout, but rather wait for it to happen. Further analysis should be applied to the breakout by looking for gaps, accelerated price movements and volume for http://www.stockcharts.com/education/What/ChartAnalysis/symmTriangle-print.html (2 of 4) [2/18/2003 5:18:27 AM]

StockCharts.com - Symmetrical Triangle (Continuation)

confirmation. Confirmation is especially important for upside breakouts. Prices sometimes return to the breakout point of apex on a reaction move before resuming in the direction of the breakout. This return can offer a second chance to participate with a better reward to risk ratio. Potential reward price targets found by measurement and parallel trendline extension are only meant to act as rough guidelines. Technical analysis is dynamic and ongoing assessment is required. In the first example above, SUNW may have fulfilled its target (42) in a few months, but the stock gave no sign of slowing down and advanced above 100 in the following months.

Conseco formed a rather large symmetrical triangle over a 5-month period before breaking out on the downside.

http://www.stockcharts.com/education/What/ChartAnalysis/symmTriangle-print.html (3 of 4) [2/18/2003 5:18:27 AM]

StockCharts.com - Symmetrical Triangle (Continuation)

1. The stock declined from 50 in Mar-98 to 22 in Oct-98 before beginning to firm and consolidate. The low at 22 probably was an over-reaction, but the long-term trend was down and established for almost a year. 2. After the first 4 points formed, the lines of the symmetrical triangle were draw. The stock traded within the boundaries for another 2 months to form the last 2 points. 3. After the gap up from point 3 to point 4, volume slowed over the next few months. There was some increase in volume in late June, but the 60-day SMA remained in a downtrend as the pattern took shape. 4. The red square marks the ideal breakout time-span from 50% to 75% of the pattern. The breakout occurred a little over 2 weeks later, but proved valid nonetheless. While it is preferable to have an ideal pattern develop, it is also quite rare. 5. After points 5 and 6 formed, the price action moved to the lower boundary of the pattern. Even at this point, the direction of the breakout was still a guess and its was prudent to wait. The break occurred with an increase in volume and accelerated price decline. Chaikin Money Flow declined past -30% and volume exceeded the 60-day SMA for an extended period. 6. After the decline from 29 1/2 to 25 1/2, the stock rebounded, but failed to reach potential resistance from the apex. The weakness of the reaction rally foreshadowed the sharpness of the decline that followed. 7. The widest point on the pattern extended 10 1/2 points. With a break of support at 29 1/2, the measured decline was estimated to around 19. By drawing a trendline parallel to the upper boundary of the pattern, the extension estimates a decline to around 20.

Written by Arthur Hill Send us your Feedback!

©2002 StockCharts.com All Rights Reserved Terms of Use

http://www.stockcharts.com/education/What/ChartAnalysis/symmTriangle-print.html (4 of 4) [2/18/2003 5:18:27 AM]

StockCharts.com - Ascending Triangle (Continuation)

Ascending Triangle (Continuation) The ascending triangle is a bullish formation that usually forms during an uptrend as a continuation pattern. There are instances when ascending triangles form as reversal patterns at the end of a downtrend, but they are typically continuation patterns. Regardless of where they form, ascending triangles are bullish patterns that indicate accumulation.

Because of its shape, the pattern can also be referred to as a right-angle triangle. Two or more equal highs form a horizontal line at the top. Two or more rising troughs form

http://www.stockcharts.com/education/What/ChartAnalysis/triangle-Ascending-print.html (1 of 4) [2/18/2003 5:19:13 AM]

StockCharts.com - Ascending Triangle (Continuation)

an ascending trendline that converges on the horizontal line as it rises. If both lines were extended right, the ascending trendline could act as the hypotenuse of a right triangle. If a perpendicular line were drawn extending down from the left end of the horizontal line, a right triangle would form. Let's examine each individual part of the pattern and then look at an example. 1. Trend: In order to qualify as a continuation pattern, an established trend should exist. However, because the ascending triangle is a bullish pattern, the length and duration of the current trend is not as important. The robustness of the formation is paramount. 2. Top Horizontal Line: At least 2 reaction highs are required to form the top horizontal line. The highs do not have to be exact, but should be within reasonable proximity of each other. There should be some distance between the highs, and a reaction low between them. 3. Lower Ascending Trendline: At least two reaction lows are required to form the lower ascending trendline. These reaction lows should be successively higher and there should be some distance between the lows. If a more recent reaction low is equal to or less than the previous reaction low, then the ascending triangle is not valid. 4. Duration: The length of the pattern can range from a few weeks to many months with the average pattern lasting from 1-3 months. 5. Volume: As the pattern develops, volume usually contracts. When the upside breakout occurs, there should be an expansion of volume to confirm the breakout. While volume confirmation is preferred, it is not always necessary. 6. Return to breakout: A basic tenet of technical analysis is that resistance turns into support and vice versa. When the horizontal resistance line of the ascending triangle is broken, it turns into support. Sometimes there will be a return to this support level before the move begins in earnest. 7. Target: Once the breakout has occurred, the price projection is found by measuring the widest distance of the pattern and applying it to the resistance breakout. In contrast to the symmetrical triangle, an ascending triangle has a definitive bullish bias before the actual breakout. If you will recall, the symmetrical triangle is a neutral formation that relies on the impending breakout to dictate the direction of the next move. On the ascending triangle, the horizontal line represents overhead supply that prevents the security from moving past a certain level. It is as if a large sell order has been placed at this level and it is taking a number of weeks or months to execute, thus preventing the price from rising further. Even though the price cannot rise past this level, the reaction lows continue to rise. It is these higher lows that indicate increased buying pressure and give the ascending triangle its bullish bias.

http://www.stockcharts.com/education/What/ChartAnalysis/triangle-Ascending-print.html (2 of 4) [2/18/2003 5:19:13 AM]

StockCharts.com - Ascending Triangle (Continuation)

Primus Telecom formed an ascending triangle over a 6-month period before breaking resistance with an expansion of volume. ●

●

●

From a low around 6, the stock established an uptrend by forming a higher low at 9 3/8 and advancing to a new reaction high early June. After recording its highest price in 10 months, the stock met resistance at 24. In June, the stock hit resistance at 23 a number of times and then again at 24 in July. The stock bounced off 24 at least three times in 5 months to form the horizontal resistance line. It was as if portions of a large block were being sold each time the stock neared 24. The reaction lows were progressively higher and formed an ascending trendline. The first low in May-99 occurred with a large spike down to 12 1/4, but the trendline was drawn to connect the prices grouped around 14. The ascending trendline could have been drawn to start at 12 1/4 and this version is shown with the gray trendline. The important thing is that there are at least two distinct reaction lows that are consecutively higher.

http://www.stockcharts.com/education/What/ChartAnalysis/triangle-Ascending-print.html (3 of 4) [2/18/2003 5:19:13 AM]

StockCharts.com - Ascending Triangle (Continuation) ●

●

●

●

The duration of the pattern is around 6 months, which may seem a bit long. However, all the key ingredients for a robust pattern were in place. Volume declined from late June until early October. There was a huge expansion when the stock fell from 23 7/16 (point 6) to 19 3/8 on two heavy trading days in October. However, this was only for two days and the stock found support around 20 to form a higher low. In keeping with the ideal pattern, the next expansion of volume occurred in late October when the stock broke resistance at 24. The stock traded at above average volume 7 of the 10 days surrounding the breakout, and all 7 were up days. Chaikin Money Flow dragged a bit from the two heavy down days, but recovered to +20% five days after the breakout. (The 10-day SMA of volume was overlaid on the price plot; the gray volume bars are up days and the black volume bars are down days). The stock advanced to 30 3/4 before pulling back to around 26. Support was found above the original resistance breakout and this indicated underlying strength in the stock. The initial advance was projected to be 10 (24 -14 = 10) points from the breakout at 24, making a target of 34. This target was reached within 2 months, but the stock didn't slow down until reaching 50 in March. Targets are only meant to be used as guidelines and other aspects of technical analysis should also be employed for deciding when to sell.

Written by Arthur Hill Send us your Feedback!

©2002 StockCharts.com All Rights Reserved Terms of Use

http://www.stockcharts.com/education/What/ChartAnalysis/triangle-Ascending-print.html (4 of 4) [2/18/2003 5:19:13 AM]

StockCharts.com - Descending Triangle

Descending Triangle The descending triangle is a bearish formation that usually forms during a downtrend as a continuation pattern. There are instances when descending triangles form as reversal patterns at the end of an uptrend, but they are typically continuation patterns. Regardless of where they form, descending triangles are bearish patterns that indicate distribution.

Because of its shape, the pattern can also be referred to as a right-angle triangle. Two or more comparable lows form a horizontal line at the bottom. Two or more declining peaks form a descending trendline above that converges with the horizontal line as it descends. If both lines were extended right, the descending trendline could act as the hypotenuse of a right triangle. If a perpendicular line were drawn extending up from the left end of the horizontal line, a right triangle would form. Let's examine each individual http://www.stockcharts.com/education/What/ChartAnalysis/triangle-Descending-print.html (1 of 4) [2/18/2003 5:19:26 AM]

StockCharts.com - Descending Triangle

part of the pattern and then look at an example. 1. Trend: In order to qualify as a continuation pattern, an established trend should exist. However, because the descending triangle is definitely a bearish pattern, the length and duration of the current trend is not as important. The robustness of the formation is paramount. 2. Lower Horizontal Line: At least 2 reaction lows are required to form the lower horizontal line. The lows do not have to be exact, but should be within reasonable proximity of each other. There should be some distance separating the lows and a reaction high between them. 3. Upper Descending Trendline: At least two reaction highs are required to form the upper descending trendline. These reaction highs should be successively lower and there should be some distance between the highs. If a more recent reaction high is equal to or greater than the previous reaction high, then the descending triangle is not valid. 4. Duration: The length of the pattern can range from a few weeks to many months, with the average pattern lasting from 1-3 months. 5. Volume: As the pattern develops, volume usually contracts. When the downside break occurs, there would ideally be an expansion of volume for confirmation. While volume confirmation is preferred, it is not always necessary. 6. Return to breakout: A basic tenet of technical analysis is that broken support turns into resistance and visa versa. When the horizontal support line of the descending triangle is broken, it turns into resistance. Sometimes there will be a return to this newfound resistance level before the down move begins in earnest. 7. Target: Once the breakout has occurred, the price projection is found by measuring the widest distance of the pattern and subtracting it from the resistance breakout. In contrast to the symmetrical triangle, a descending triangle has a definite bearish bias before the actual break. The symmetrical triangle is a neutral formation that relies on the impending breakout to dictate the direction of the next move. For the descending triangle, the horizontal line represents demand that prevents the security from declining past a certain level. It is as if a large buy order has been placed at this level and it is taking a number of weeks or months to execute, thus preventing the price from declining further. Even though the price does not decline past this level, the reaction highs continue to decline. It is these lower highs that indicate increased selling pressure and give the descending triangle its bearish bias.

http://www.stockcharts.com/education/What/ChartAnalysis/triangle-Descending-print.html (2 of 4) [2/18/2003 5:19:26 AM]

StockCharts.com - Descending Triangle

After recording a lower high just below 60 in Dec-99, Nucor formed a descending triangle early in 2000. In late April, the stock broke support with a gap down, sharp break and increase in volume to complete the formation. ●

●

●

The stock declined from above 60 to the low 40s before finding some support and mounting a reaction rally. The rally stalled just below 50 and a series of lower reaction highs began to form. The long-term trend was down and the resulting pattern was classified as continuation. Support at 45 was first established with a bounce in February. After that, the stock touched this level two more times before breaking down. After the second touch in March (about a month later), the lower support line was drawn. After each bounce off support, a lower high formed. The reaction highs at points 2,4 and 6 formed the descending trendline to mark the potential descending

http://www.stockcharts.com/education/What/ChartAnalysis/triangle-Descending-print.html (3 of 4) [2/18/2003 5:19:26 AM]

StockCharts.com - Descending Triangle

● ●

●

●

triangle pattern. I say potential because the pattern is not complete until support is broken. The duration of the pattern was a little less than 3 months. The last touch of support at 45 occurred in late April. The stock spiked down through support, but managed to close above this key level. The final break occurred a few days later with a gap down, a considerable black candlestick and an expansion in volume. The way support is broken can offer insight into the general weakness of a security. This was not a slight break, but a rather convincing break. Volume jumped to the highest level in many months and money flows broke below -10%. After falling from 45 to 41, the stock mounted a feeble reaction rally that only lasted three days and produced two candlesticks with long upper shadows. Sometimes there is a test of the newfound resistance level, and sometimes there isn't. A weak test of support can indicate acute selling pressure. The initial decline was projected to be 9 points (54 -45 = 9). If this is subtracted from the support break at 45, the downside projection is to around 36. Even though the stock exceeded this target in late June, recent strength has brought it back near 36. Targets are only meant to be used as guidelines and other aspects of technical analysis should also be employed for deciding when to cover a short or buy.

Written by Arthur Hill Send us your Feedback!

©2002 StockCharts.com All Rights Reserved Terms of Use

http://www.stockcharts.com/education/What/ChartAnalysis/triangle-Descending-print.html (4 of 4) [2/18/2003 5:19:26 AM]

StockCharts.com - Price Channel

Price Channel A price channel is a continuation pattern that slopes up or down and is bound by an upper and lower trendline. The upper trendline marks resistance and the lower trendline marks support. Price channels with negative slopes (down) are considered bearish and those with positive slopes (up) bullish. For explanatory purposes, a "bullish price channel" will refer to a channel with positive slope and a "bearish price channel" to a channel with negative slope.

1. Main trendline: It takes at least two points to draw the main trendline. This line sets the tone for the trend and the slope. For a bullish price channel, the main trendline extends up and at least two reaction lows are required to draw it. For a bearish price channel, the main trendline extends down and at least two reaction http://www.stockcharts.com/education/What/ChartAnalysis/priceChannel-print.html (1 of 4) [2/18/2003 5:19:37 AM]

StockCharts.com - Price Channel

2.

3.

4.

5.

highs are required to draw it. Channel line: The line drawn parallel to the main trendline is called the channel line. Ideally, the channel line will be based off of two reaction highs or lows. However, after the main trendline has been established, some analysts draw the parallel channel line using only one reaction high or low. The channel line marks support in a bearish price channel and resistance in a bullish price channel. Bullish price channel: As long as prices advance and trade within the channel, the trend is considered bullish. The first warning of a trend change occurs when prices fall short of channel line resistance. A subsequent break below main trendline support would provide further indication of a trend change. A break above channel line resistance would be bullish and indicate an acceleration of the advance. Bearish price channel: As long as prices decline and trade within the channel, the trend is considered bearish. The first warning of a trend change occurs when prices fail to reach channel line support. A subsequent break above main trendline resistance would provide further indication of a trend change. A break below channel line support would be bearish and indicate an acceleration of the decline. Scaling: Even though it is a matter of personal preference, trendlines seem to match reaction highs and lows best when semi-log scales are used. Semi-log scales reflect price movements in percentage terms. A move from 50 to 100 will appear the same distance as a move from 100 to 200.

In a bullish price channel, some traders look to buy when prices reach main trendline support. Conversely, some traders look to sell (or short) when prices reach main trendline resistance in a bearish price channel. As with most price patterns, other aspects of technical analysis should be used to confirm signals. Because technical analysis is just as much art as it is science, there is room for flexibility. Even though exact trendline touches are ideal, it is up to each individual to judge the relevance and placement of both the main trendline and the channel line. By that same token, a channel line that is exactly parallel to the main trendline is ideal.

http://www.stockcharts.com/education/What/ChartAnalysis/priceChannel-print.html (2 of 4) [2/18/2003 5:19:37 AM]

StockCharts.com - Price Channel

CSCO provides an example of an 11-month bullish price channel that developed in 1999. ●

●

●

●

●

●

Main trendline: The January, February and March reaction lows formed the beginning of the main trendline. Subsequent lows in April, May and August confirmed the main trendline. Channel line: Once the main trendline was in place, the channel line beginning from the January high was drawn. A visual assessment reveals that these trendlines look parallel. More precise analysts may want to test the slope of each line, but a visual inspection is usually enough to ensure the "essence" of the pattern. Bullish price channel: Subsequent touches along the main trendline offered good buying opportunities in mid April, late May and mid August. The stock did not reach channel line resistance until July (red arrow) and this marked a significant reaction high. The September high (blue arrow) fell short of channel line resistance, but only by a small margin that was probably insignificant. The break above channel line resistance in Dec-99 marked an acceleration of the advance. Some analysts might consider the stock overextended after this move, but the advance was powerful and the trend never turned bearish. Price channels will not last forever, but the underlying trend remains in place until proven otherwise.

http://www.stockcharts.com/education/What/ChartAnalysis/priceChannel-print.html (3 of 4) [2/18/2003 5:19:37 AM]

StockCharts.com - Price Channel

Written by Arthur Hill Send us your Feedback!

©2002 StockCharts.com All Rights Reserved Terms of Use

http://www.stockcharts.com/education/What/ChartAnalysis/priceChannel-print.html (4 of 4) [2/18/2003 5:19:37 AM]

StockCharts.com - Rectangle (Continuation Pattern)

Rectangle (Continuation Pattern) A rectangle is a continuation pattern that forms as a trading range during a pause in the trend. The pattern is easily identifiable by two comparable highs and two comparable lows. The highs and lows can be connected to form two parallel lines that make up the top and bottom of a rectangle. Rectangles are sometimes referred to as trading ranges, consolidation zones or congestion areas.

There are many similarities between the rectangle and the symmetrical triangle. While both are usually continuation patterns, they can also mark trend significant tops and http://www.stockcharts.com/education/What/ChartAnalysis/rectangle-print.html (1 of 4) [2/18/2003 5:19:48 AM]

StockCharts.com - Rectangle (Continuation Pattern)

bottoms. As with the symmetrical triangle, the rectangle pattern is not complete until a breakout has occurred. Sometimes clues can be found, but the direction of the breakout is usually not determinable beforehand. We will examine each part of the rectangle and then provide an example with MU. 1. Trend: To qualify as a continuation pattern, a prior trend should exist. Ideally, the trend should be a few months old and not too mature. The more mature the trend, the less chance that the pattern marks a continuation. 2. 4 points: At least two equivalent reaction highs are required to form the upper resistance line and two equivalent reaction lows to form the lower support line. They do not have to be exactly equal, but should be within a reasonable proximity. Although not a prerequisite, it is preferable that the highs and lows alternate. 3. Volume: As opposed to the symmetrical triangle, rectangles do not exhibit standard volume patterns. Sometimes volume will decline as the pattern develops. Other times volume will gyrate as the prices bounce between support and resistance. Rarely will volume increase as the pattern matures. If volume declines, it is best to look for an expansion on the breakout for confirmation. If volume gyrates, it is best to assess which movements (advances to resistance or declines to support) are receiving the most volume. This type of volume assessment could offer an indication on the direction of the future breakout. 4. Duration: Rectangles can extend for a few weeks or many months. If the pattern is less than 3 weeks, it is usually considered a flag, also a continuation pattern. Ideally, rectangles will develop over a 3-month period. Generally, the longer the pattern, the more significant the breakout. A 3-month pattern might be expected to fulfill its breakout projection. However, a 6-month pattern might be expected to exceed its breakout target. 5. Breakout Direction: The direction of the next significant move can only be determined after the breakout has occurred. As with the symmetrical triangle, rectangles are neutral patterns that are dependent on the direction of the future breakout. Volume patterns can sometimes offer clues, but there is no confirmation until an actual break above resistance or break below support. 6. Breakout Confirmation: For a breakout to be considered valid, it should be on a closing basis. Some traders apply a filter to price (3%), time (3 days) or volume (expansion) for confirmation. 7. Return to Breakout: A basic tenet of technical analysis is that broken support turns into potential resistance and visa versa. After a break above resistance (below support), there is sometimes a return to test this newfound support level (resistance level). (For more detail, see this article on support and resistance.) A return to or near the original breakout level can offer a second chance to participate. 8. Target: The estimated move is found by measuring the height of the rectangle and applying it to the breakout. Rectangles represent a trading range that pits the bulls against the bears. As the price nears support, buyers step in and push the price higher. As the price nears resistance, http://www.stockcharts.com/education/What/ChartAnalysis/rectangle-print.html (2 of 4) [2/18/2003 5:19:48 AM]

StockCharts.com - Rectangle (Continuation Pattern)

bears take over and force the price lower. Nimble traders sometimes play these bounces by buying near support and selling near resistance. One group (bulls or bears) will exhaust itself and a winner will emerge when there is a breakout. Again, it is important to remember that rectangles have a neutral bias. Even though clues can sometimes be gleaned from volume patterns, the actual price action depicts a market in conflict. Only until the price breaks above resistance or below support will it be clear which group has won the battle.

In the summer of 1999, Micron Electronics (MU) advanced from the high teens to the low forties. After meeting resistance around 42, the stock settled in a trading range between 40 and 30 to form a rectangle. ●

The prior intermediate trend was established as bullish by the advance from the high teens to the low forties. However, it was unclear at the time if this trading range would be a reversal or a continuation pattern. The horizontal resistance line at 40 can be extended back to the Feb-99 high and marked a serious resistance

http://www.stockcharts.com/education/What/ChartAnalysis/rectangle-print.html (3 of 4) [2/18/2003 5:19:48 AM]

StockCharts.com - Rectangle (Continuation Pattern)

●

●

●

●

●

●

level. The red resistance line at 40 was formed with three reaction highs. The first reaction high may be a bit suspect, but the second two are robust. The parallel support line at 30 was touched three times and established a solid support level. After the high at point 5 was reached, the rectangle was valid. As the pattern developed, volume fluctuated and there was no clear indication (bullish or bearish break) until mid-February. The first bullish clue came when the stock declined from 38 to 31 and Chaikin Money Flow failed to move below -10%. Money flows held steady throughout the decline and turned positive as soon as the stock turned back up. By the time the stock reached 39 3/4 (surpassing its previous reaction high in the process), CMF was at +20%. Also notice the strength behind the advance after a higher low. The duration of the pattern was 5 months. Due to long-term overhead resistance at 40, the pattern needed more time to consolidate before a breakout. The longer consolidation made for bigger expectations after the breakout. The breakout occurred with a large expansion in volume and a huge moved above resistance. After the breakout, there was a slight pullback to around 46, but the volume behind the advance indicated a huge breakout. Stocks do not always return to the point of breakout. In the example above, LMT makes a classic return to the breakout. The set up and strength behind the breakout should be assessed to determine the possibility of a second chance opportunity. The target advance of this breakout was 10 points, which was the width of the pattern. However, judging from the duration and strength of the breakout, expansion of volume and new all-time highs, it was apparent that this was no ordinary breakout. Therefore an ordinary target was useless! After an initial advance as high as 55 13/16, the stock pulled back to 46 and then moved above 70. Another trading range subsequently developed with resistance in the low 70s and support in the upper 40s.

Written by Arthur Hill Send us your Feedback!

©2002 StockCharts.com All Rights Reserved Terms of Use

http://www.stockcharts.com/education/What/ChartAnalysis/rectangle-print.html (4 of 4) [2/18/2003 5:19:48 AM]

StockCharts.com - Measured (Bull) Move (Continuation)

Measured (Bull) Move (Continuation) The Measured Move is a three-part formation that begins as a reversal pattern and resumes as a continuation pattern. The Measured (Bull) Move consists of a reversal advance, correction/consolidation and continuation advance. Because the Measured (Bull) Move cannot be properly identified until after the correction/consolidation period, I have elected to categorize it as a continuation pattern. The pattern is usually longterm and forms over several months.

http://www.stockcharts.com/education/What/ChartAnalysis/measuredBullMove-print.html (1 of 4) [2/18/2003 5:20:01 AM]

StockCharts.com - Measured (Bull) Move (Continuation)

1. Prior Trend: For the first advance to qualify as a reversal, there must be evidence of a prior downtrend to reverse. Because the Measured (Bull) Move can occur as part of a larger advance, the length and severity of the prior decline may vary from a few weeks to many months. 2. Reversal Advance: The first advance usually begins near the established lows of the previous decline and extends for a few weeks or many months. Sometimes a reversal pattern can mark the initial trend change. Other times the new uptrend is established by new reaction highs or a break above resistance. Ideally, the advance is fairly orderly and lengthy with a series of rising peaks and troughs that may form a price channel. Less erratic advances are satisfactory, but run the risk of forming a different pattern. 3. Consolidation/Correction: After an extended advance, some sort of consolidation or correction can be expected. As a consolidation, there could be a continuation pattern such as a rectangle or ascending triangle. As a correction, there could be 33% to 67% retracement of the previous advance and the possible patterns include a large downward-sloping flag or falling wedge. Generally speaking, the bigger the advance, the bigger the correction. A 100% advance may see a 62% correction and a 50% advance may see only a 33% correction. 4. Continuation Advance - Length: The distance from the low to the high of the first advance can be applied to the low of the consolidation/retracement to estimate a projected advance. Some technicians like to measure by points, others in percentage terms. If the first advance was from 30 to 50 (20 points) and the consolidation/correction was to 40, then 60 would be the target of the second advance (50 - 30 = 20 : 40 + 20 = 60). For those who prefer percentages: if the first advance was from 30 to 50 (66%) and the consolidation/correction was to 40, then 66.40 would be the target of the second advance (40 X 66% = 26.40 : 40 + 26.40 = 66.40). The decision of which method to use will depend on the individual security and your analysis style. 5. Continuation Advance - Entry: If the consolidation/correction is made up of a continuation pattern, then second leg entry points can be identified using the normal breakout rules. However, if there is no readily identifiable pattern, then some other continuation breakout signal must be sought. In this case, much will depend on your trading style, objectives, risk tolerance and time horizon. One method might be to measure potential retracements (33%, 50%, or 62%) and look for short-term reversal patterns for good reward-to-risk entry points. Another method might be to wait for a break above the reaction high set by the first advance as confirmation of continuation. This method would make for a late entry, but the pattern would be confirmed. 6. Volume: Volume should increase at the beginning of the reversal advance, decrease at the end of the consolidation/correction and increase again at the beginning of the continuation advance. The Measured (Bull) Move can be made up of a number of patterns. There could be a double bottom to start the reversal advance, a price channel during the reversal http://www.stockcharts.com/education/What/ChartAnalysis/measuredBullMove-print.html (2 of 4) [2/18/2003 5:20:01 AM]

StockCharts.com - Measured (Bull) Move (Continuation)

advance, an ascending triangle to mark the consolidation and another price channel to mark the continuation advance. During multi-year bull markets (or bear markets), a series of Measured (Bull) Moves can form. While the projections for the continuation advance can be helpful for targets, they should only be used as rough guidelines. Securities can overshoot their targets, but also fall short -- technical assessments should be ongoing.

Intel (INTC) broke out of a multi-year slump and began a Measured (Bull) Move. ●

Prior Trend: After a large downward sloping trading range throughout most of 1997 and 1998, Intel broke above resistance in early November (blue arrows) and started the first leg of a Measured (Bull) Move.

http://www.stockcharts.com/education/What/ChartAnalysis/measuredBullMove-print.html (3 of 4) [2/18/2003 5:20:01 AM]

StockCharts.com - Measured (Bull) Move (Continuation) ●

●

●

●

●

Reversal Advance: The breakout occurred with a strong move above resistance at 22 with 2 weeks of strong volume (green arrows). The advance began from 17.44 and ended at 35.92. Consolidation/Correction: After an extended advance, the stock declined within a set range that resembled a large descending flag. The decline retraced about 54% of the previous advance. Continuation Advance - Length: The estimated length of the advance was 18.48 points from the June low at 25.94, which would target 44.42. The actual high was 44.75 for a 18.81 advance. Continuation Advance - Entry: Because the consolidation/correction portion formed a continuation pattern, entry could have been based on a break above the resistance line (red arrow). Volume: Volume increased in early November at the beginning of the reversal advance. There was a decrease from March to May 1999. And, volume increased at the beginning of the continuation advance (green arrows).

Written by Arthur Hill Send us your Feedback!

©2002 StockCharts.com All Rights Reserved Terms of Use

http://www.stockcharts.com/education/What/ChartAnalysis/measuredBullMove-print.html (4 of 4) [2/18/2003 5:20:01 AM]

StockCharts.com - Measured (Bear) Move (Continuation)

Measured (Bear) Move (Continuation) The Measured Move is a three-part formation that begins as a reversal pattern and resumes as a continuation pattern. The Measured (Bear) Move consists of a reversal decline, consolidation/retracement and continuation decline. Because the Measured (Bear) Move cannot be confirmed until after the consolidation/retracement period, I have elected to categorize it as a continuation pattern. The pattern is usually long-term and forms over several months.

http://www.stockcharts.com/education/What/ChartAnalysis/measuredBearMove-print.html (1 of 4) [2/18/2003 5:20:14 AM]

StockCharts.com - Measured (Bear) Move (Continuation)

1. Prior Trend: For the first decline to qualify as a reversal, there must be evidence of a prior uptrend to reverse. Because the Measured (Bear) Move can occur as part of a larger advance, the length and severity of the prior decline may vary from a few weeks to many months. 2. Reversal Decline: The first decline usually begins near the established highs of the previous advance and extends for a few weeks or many months. Sometimes this reversal pattern can mark the initial trend change, other times a new downtrend is established by new reaction lows or a break below support. Ideally, the decline is fairly orderly and lengthy with a series of declining peaks and troughs that may form a price channel. Less erratic declines are satisfactory, but run the risk of turning into a different pattern. 3. Consolidation/Retracement: After an extended decline, some sort of consolidation or retracement can be expected. As a retracement rally (or reaction rally), prices could recoup 33% to 67% of the previous decline. Generally speaking, the bigger the decline is, the bigger the reaction rally. Some retracement formations might include an upward sloping flag or rising wedge. If the formation turns out to be a consolidation, then a continuation pattern such as a rectangle or descending triangle could form. 4. Continuation Decline - Length: The distance from the high to the low of the first decline can be applied to the high of the consolidation/retracement to estimate the length of the next decline. Some technicians like to measure by points, others in percentage terms. If a security declines from 60 to 40 (20 points) and the consolidation/retracement rally returns to the security to 50, then 30 would be the target of the second decline (50 - 20 = 30). Using the percentage method, the decline from 60 to 40 would be -33% and projected decline from 50 would be 16.50. (50 X 33% = 16.50 : 50 - 16.5 = 33.50). Deciding which method to use will depend on the individual security and your analysis preferences. 5. Continuation Decline - Entry: If the consolidation/retracement forms a continuation pattern, then an appropriate second leg entry point can be identified using traditional technical analysis rules. However, if there is no readily identifiable pattern, then some other signal must be sought. In this case, much will depend on your trading preferences, objectives, risk tolerance and time horizon. One method might be to measure potential retracements (33%, 50% or 62%) and look for short-term reversal patterns. Another method might be to look for a break below the reaction low set by the first decline as confirmation of continuation. This method would make for a late entry, but the Measured (bear) Move pattern would be confirmed. 6. Volume: Volume should increase during the reversal decline, decrease at the end of the consolidation/retracement and increase again during the continuation decline. This is the ideal volume pattern, but volume confirmation for bearish patterns is not as important as for bullish patterns. More than one pattern can exist within the context of a Measured (Bear) Move. A double http://www.stockcharts.com/education/What/ChartAnalysis/measuredBearMove-print.html (2 of 4) [2/18/2003 5:20:14 AM]

StockCharts.com - Measured (Bear) Move (Continuation)

top could mark the first reversal and decline, a price channel could form during this decline, a descending triangle could mark the consolidation and another price channel could form during the continuation decline. During multi-year bear markets (or bull markets), a series of Measured (Bear) Moves can form. A bear move consisting of three down legs might include a reversal and decline for the first leg, a retracement, a decline for the second leg, a retracement and finally the third leg decline. While the projection targets for the continuation decline can be helpful, they should only be used as rough guidelines. Securities can overshoot their targets, but also fall short and technical assessments should be ongoing.

http://www.stockcharts.com/education/What/ChartAnalysis/measuredBearMove-print.html (3 of 4) [2/18/2003 5:20:14 AM]

StockCharts.com - Measured (Bear) Move (Continuation)

As illustrated in the chart above, the second decline of a Measured (Bear) Move may not be as orderly as the first, especially when volatile stocks are involved. ●

●

●

●

●

●

Prior Trend: After a multi-year bull move, XIRC reached its all-time high at 69.69 on 31-Dec-99. Reversal Decline: The stock broke trendline support in Jan-00 and a lower low was recorded when the stock dropped below 45 in Feb-00. The decline took the stock to 29.13 in Apr-00 for a total of 40.56 points down. Consolidation/Correction: In April, May and June, the stock recouped about 50% of its previous decline with a retracement rally to 52.75. Including the spike high at 52.75, a parallel price channel formed (resembling a large flag) with support marked by the lower trendline. Excluding the spike high, the interpretation could have been a rising wedge. Either way, support was marked by the lower trendline. Continuation Decline - Length: The estimated length of the continuation decline was 40.56 points from the June high at 52.75, which would target 12.19. Percentage estimates can sometimes be more applicable to Measured (Bear) Moves, especially if the target appears unusually low. The decline from 69.69 to 29.13 was 58%. A 58% decline from 52.75 would mark a target around 22.16 (52.75 x .58 = 30.59 : 52.75 - 30.59 = 22.16). Continuation Decline - Entry: Because the consolidation/retracement portion formed a continuation pattern, entry could have been based on a break below the support trendline line (red arrows). Volume: Volume increased just prior to the trendline support break in Jan-00 and again when the stock broke below its previous reaction low (blue arrows). Later when the stock broke trendline support in July, volume also increased significantly (red arrows).

Written by Arthur Hill Send us your Feedback!

©2002 StockCharts.com All Rights Reserved Terms of Use

http://www.stockcharts.com/education/What/ChartAnalysis/measuredBearMove-print.html (4 of 4) [2/18/2003 5:20:14 AM]

Indicator Analysis -- Chart School

SharpChart: Symbol Catalog

You are logged out Log in

You are here: Chart School > What is TA? > Indicator Analysis

Search the Site:

Advanced Search

Indicator Analysis

Chart School Technical Analysis Overview Chart Analysis Indicator Analysis Market Analysis Trading Strategies Analysis Tools SharpCharts PerfCharts Point & Figure Charts Stock Scans Market Carpet Additional Resources Bookstore Glossary Newsletter Archives Mailbag Articles Using StockCharts.com Recommended Sites

Join Now!

Introduction to Indicators-

Part 1 Accumulation/Distribution Line-

Part 2

Part 3

Part 4

A volume indicator, the Accumulation/Distribution Line was developed by Marc Chaikin to assess the cumulative flow of money into and out of a security.

Aroon and Aroon Oscillator-

A set of oscillators similar to the ADX system. They help determine the strength and direction of the current trend.

Average Directional Index (ADX)-

An oscillator that assesses the strength of current trends, and can also be used to identify potential changes in a market from trending to non-trending.

Average True Range (ATR)Our Bookstore Books on: Our Favorites Technical Analysis Books by John Murphy P&F Charting General Investing

An introduction to the concept of indicators. Identify reasons to use them in your analysis, and shed light on the difference between leading and lagging indicators.

Bollinger Bands-

Bollinger Band WidthCommodity Channel Index (CCI)-

An indicator that measures a security's volatility, but gives no indication of price direction or duration. An indicator that allows users to compare volatility and relative price levels over a period of time. An indicator of volatility An oscillator used to identify changes and strength in trend, and find buy or sell signals.

http://www.stockcharts.com/education/What/IndicatorAnalysis/index.html (1 of 4) [2/18/2003 5:22:22 AM]

Indicator Analysis -- Chart School

Chaikin Money Flow-

Best used in conjunction with other aspects of technical analysis, this indicator focuses on the location of the close relative to the range for the period (daily or weekly). Part 1

Chaikin Oscillator-

MACD-

Technically an indicator of an indicator, the Chaikin Oscillator gives momentum characteristics to the Accumulation/Distribution Line. One of the simplest and most reliable indicators available, MACD uses moving averages, which are lagging indicators, to include some trend-following characteristics. Part 1

Moving Averages-

Price Oscillator (including PPO)-

Part 2

Part 3

Part 4

MACD Histogram

One of the most popular and easy to use tools available to the technical analyst. By using an average of prices, moving averages smooth a data series and make it easier to spot trends. Part 1

Percentage Volume Oscillator (PVO)-

Part 2

Part 2

The percentage difference between two moving averages of volume. The PVO can be used to identify periods of expanding or contracting volume. An indicator based on the difference between two moving averages, expressed as either a percentage or in absolute terms.

Price Relative-

Compares the performance of one security to another. It is often used to compare the performance of a particular stock to a market index, usually the S&P 500.

Price By Volume-

Indicates the above of volume that occurred at various price levels on a chart.

Rabbitt Q-StockRank-

A combination of nine fundamental and technical models applied to over 3000 stocks daily. The Q-StockRank is a starting point that identifies stocks to which you may then apply your own experience, insights, judgment, and knowledge.

http://www.stockcharts.com/education/What/IndicatorAnalysis/index.html (2 of 4) [2/18/2003 5:22:22 AM]

Indicator Analysis -- Chart School

Relative Strength Index (RSI)-

Standard Deviation-

A momentum oscillator that compares the magnitude of gains against the magnitude of losses. A statistical term that provides a good indication of volatility. It measures how widely values are dispersed from the average.

Stochastic Oscillator-

A momentum indicator that shows the location of the current close relative to the high/low range over a set number of periods.

StochRSI-

An oscillator that measures the level of RSI relative to its range, over a set period of time by applying the formula behind Stochastics.

TRIN-

VIX-

Ultimate Oscillator-

A contrarian indicator used to detect overbought and oversold levels in the market. TRIN has an inverse relationship with the market. A weighted measure of implied volatility for 8 OEX put and call options. VIX has an inverse relationship to the market. A bounded oscillator that incorporates three different time frames into one number.

Williams %R-

A momentum indicator especially popular for measuring overbought and oversold levels.

ZigZag-

ZigZag isn't a true indicator, but a means to filter chart noise and compare relative price movements. Beware -- ZigZag has zero predictive power!

Financial Ad Trader

http://www.stockcharts.com/education/What/IndicatorAnalysis/index.html (3 of 4) [2/18/2003 5:22:22 AM]

Indicator Analysis -- Chart School

Join Now! | Newsletter | FAQ | Glossary | Terms of Use Home | Free Charts | Chart School | Members | Support Data provided by: Unless otherwise indicated, all data is delayed by 20 minutes ©1999-2003 StockCharts.com All Rights Reserved

http://www.stockcharts.com/education/What/IndicatorAnalysis/index.html (4 of 4) [2/18/2003 5:22:22 AM]

StockCharts.com - Indicators Part 1

Indicators Part 1

Introduction

This article is designed to introduce the concept of indicators and explain how to use them in your analysis. We will shed light on the difference between leading and lagging indicators, as well as look into the benefits and drawbacks. Many, if not most, popular indicators are shown as oscillators. With this in mind, we will also show how to read oscillators and explain how signals are derived. Later in this series on indicators, we will turn our focus to specific indicators and provide examples of signals in action. What is an Indicator?

An indicator is a series of data points that are derived by applying a formula to the price data of a security. Price data includes any combination of the open, high, low or close over a period of time. Some indicators may use only the closing prices, while others incorporate volume and open interest into their formulas. The price data is entered into the formula and a data point is produced. For example, the average of 3 closing prices is one data point ((41+43+43)/3=42.33). However, one data point does not offer much information and does not an indicator make. A series of data points over a period of time is required to create valid reference points to enable analysis. By creating a time series of data points, a comparison can be made between present and past levels. For analysis purposes, indicators are usually shown in a graphical form above or below a security’s price chart. Once shown in graphical form, an indicator can then be compared with the corresponding price chart of the security. Sometimes indicators are plotted on top of the price plot for a more direct comparison.

What does an Indicator Offer?

An indicator offers a different perspective from which to analyze the price action. Some, such as moving averages, are derived from simple formulas and the mechanics are relatively easy to understand. Others, such as Stochastics, have complex formulas and require more study to fully understand and appreciate. Regardless of the complexity of the formula, indicators can provide unique perspective on the strength and direction of the underlying price action. http://www.stockcharts.com/education/What/IndicatorAnalysis/indicators1-print.html (1 of 5) [2/18/2003 5:22:41 AM]

StockCharts.com - Indicators Part 1

A simple moving average is an indicator that calculates the average price of a security over a specified number of periods. If a security is exceptionally volatile, then a moving average will help to smooth the data. A moving average filters out random noise and offers a smoother perspective of the price action. Veritas (VRTS) displays a lot of volatility and an analyst may have difficulty discerning a trend. By applying a 10-day simple moving average to the price action, random fluctuations are smoothed to make it easier to identify a trend. Veritas (VRTS)

Why Use Indicators?

Indicators serve three broad functions: to alert, to confirm and to predict. ●

●

An indicator can act as an alert to study price action a little more closely. If momentum is waning, it may be a signal to watch for a break of support. Or, if there is a large positive divergence building, it may serve as an alert to watch for a resistance breakout. Indicators can be used to confirm other technical analysis tools. If there is a

http://www.stockcharts.com/education/What/IndicatorAnalysis/indicators1-print.html (2 of 5) [2/18/2003 5:22:41 AM]

StockCharts.com - Indicators Part 1

●

breakout on the price chart, a corresponding moving average crossover could serve to confirm the breakout. Or, if a stock breaks support, a corresponding low in the On-Balance-Volume (OBV) could serve to confirm the weakness. Some investors and traders use indicators to predict the direction of future prices.

Tips for Using Indicators

Indicators indicate. This may sound straightforward, but sometimes traders ignore the price action of a security and focus solely on an indicator. Indicators filter price action with formulas. As such, they are derivatives and not direct reflections of the price action. This should be taken into consideration when applying analysis. Any analysis of an indicator should be taken with the price action in mind. What is the indicator saying about the price action of a security? Is the price action getting stronger? Weaker? Even though it may be obvious when indicators generate buy and sell signals, the signals should be taken in context with other technical analysis tools. An indicator may flash a buy signal, but if the chart pattern shows a descending triangle with a series of declining peaks, it may be a false signal. On the Inktomi (INKT) chart, MACD improved from April to August and formed a positive divergence in August. All the earmarks of a MACD buying opportunity were present, but the stock failed to break above the resistance and exceed its previous reaction high. This non-confirmation from the stock should have served as a warning sign against a long position. For the record, a sell signal occurred when the stock broke support from the descending triangle in early Oct-00 . Inktomi (INKT)

http://www.stockcharts.com/education/What/IndicatorAnalysis/indicators1-print.html (3 of 5) [2/18/2003 5:22:41 AM]

StockCharts.com - Indicators Part 1

As always in technical analysis, learning how to read indicators is more of an art than a science. The same indicator may exhibit different behavioral patterns when applied to different stocks. Indicators that work well for IBM might not work the same for Delta Airlines. Through careful study and analysis, expertise with the various indicators will develop over time. As this expertise develops, certain nuances as well as favorite setups will become clear. There are hundreds of indicators in use today, with new indicators being created every week. Technical analysis software programs come with dozens of indicators built in, and even allow users to create their own. Given the amount of hype that is associated with indicators, choosing an indicator to follow can be a daunting task. Even with the introduction of hundreds of new indicators, only a select few really offer a different perspective and are worthy of attention. Strangely enough, the indicators that usually merit the most attention are those that have been around the longest time and have stood the test of time. When choosing an indicator to use for analysis, choose carefully and moderately. Attempts to cover more than five indicators are usually futile. It is best to focus on two http://www.stockcharts.com/education/What/IndicatorAnalysis/indicators1-print.html (4 of 5) [2/18/2003 5:22:41 AM]

StockCharts.com - Indicators Part 1

or three indicators and learn their intricacies inside and out. Try to choose indicators that complement each other, instead of those that move in unison and generate the same signals. For example, it would be redundant to use two indicators that are good for showing overbought and oversold levels, such as Stochastics and RSI. Both of these indicators measure momentum and both have overbought/oversold levels.

Written by Arthur Hill Part 1 | Part 2 | Part 3 | Part 4

Send us your Feedback!

©2002 StockCharts.com All Rights Reserved Terms of Use

http://www.stockcharts.com/education/What/IndicatorAnalysis/indicators1-print.html (5 of 5) [2/18/2003 5:22:41 AM]

StockCharts.com - Indicators Part 2

Indicators Part 2

Leading Indicators

As their name implies, leading indicators are designed to lead price movements. Most represent a form of price momentum over a fixed look-back period, which is the number of periods used to calculate the indicator. For example, a 20-day Stochastic Oscillator would use the past 20 days of price action (about a month) in its calculation. All prior price action would be ignored. Some of the more popular leading indicators include Commodity Channel Index (CCI), Momentum, Relative Strength Index (RSI), Stochastic Oscillator and Williams %R. Momentum Oscillators Many leading indicators come in the form of momentum oscillators. Generally speaking, momentum measures the rate-of-change of a security's price. As the price of a security rises, price momentum increases. The faster the security rises (the greater the periodover-period price change), the larger the increase in momentum. Once this rise begins to slow, momentum will also slow. As a security begins to trade flat, momentum starts to actually decline from previous high levels. However, declining momentum in the face of sideways trading is not always a bearish signal. It simply means that momentum is returning to a more median level. RSI

http://www.stockcharts.com/education/What/IndicatorAnalysis/indicators2-print.html (1 of 6) [2/18/2003 5:22:51 AM]

StockCharts.com - Indicators Part 2

Momentum indicators employ various formulas to measure price changes. RSI (a momentum indicator) compares the average price change of the advancing periods with the average change of the declining periods. On the IBM chart, RSI advanced from October to the end of November. During this period, the stock advanced from the upper 60s to the low 80s. When the stock traded sideways in the first half of December, RSI dropped rather sharply (blue lines). This consolidation in the stock was quite normal and actually healthy. From these lofty levels (near 70), flat price action would be expected to cause a a decline in RSI (and momentum). If RSI were trading around 50 and the stock began to trade flat, the indicator would not be expected to decline. The green lines on the chart mark a period of sideways trading in the stock and in RSI. RSI started from a relatively median level, around 50. The subsequent flat price action in the stock also produced relatively flat price action in the indicator and it remains around 50. Benefits and Drawbacks of Leading Indicators There are clearly many benefits to using leading indicators. Early signaling for entry and exit is the main benefit. Leading indicators generate more signals and allow more opportunities to trade. Early signals can also act to forewarn against a potential strength or weakness. Because they generate more signals, leading indicators are best used in trading markets. These indicators can be used in trending markets, but usually with the http://www.stockcharts.com/education/What/IndicatorAnalysis/indicators2-print.html (2 of 6) [2/18/2003 5:22:51 AM]

StockCharts.com - Indicators Part 2

major trend, not against it. In a market trending up, the best use is to help identify oversold conditions for buying opportunities. In a market that is trending down, leading indicators can help identify overbought situations for selling opportunities. With early signals comes the prospect of higher returns and with higher returns comes the reality of greater risk. More signals and earlier signals mean that the chances of false signals and whipsaws increase. False signals will increase the potential for losses. Whipsaws can generate commissions that can eat away profits and test trading stamina. Lagging Indicators

As their name implies, lagging indicators follow the price action and are commonly referred to as trend-following indicators. Rarely, if ever, will these indicators lead the price of a security. Trend-following indicators work best when markets or securities develop strong trends. They are designed to get traders in and keep them in as long as the trend is intact. As such, these indicators are not effective in trading or sideways markets. If used in trading markets, trend-following indicators will likely lead to many false signals and whipsaws. Some popular trend-following indicators include moving averages (exponential, simple, weighted, variable) and MACD. S&P 500

http://www.stockcharts.com/education/What/IndicatorAnalysis/indicators2-print.html (3 of 6) [2/18/2003 5:22:51 AM]

StockCharts.com - Indicators Part 2

The chart above shows the S&P 500 with the 20-day simple moving average and the 100-day simple moving average. Using a moving average crossover to generate the signals, there were seven signals over the two years covered in the chart. Over these two years, the system would have been enormously profitable. This is due to the strong trends that developed from Oct-97 to Aug-98 and from Nov-98 to Aug-99. However, notice that as soon as the index starts to move sideways in a trading range, the whipsaws begin. The signals in Nov-97 (sell), Aug-99 (sell) and Sept-99 (buy) were reversed in a matter of days. Had these moving averages been longer (50- and 200-day moving averages), there would have been fewer whipsaws. Had these moving average been shorter (10 and 50-day moving average), there would have been more whipsaws, more signals, and earlier signals. Benefits and Drawbacks of Lagging Indicators One of the main benefits of trend-following indicators is the ability to catch a move and remain in a move. Provided the market or security in question devlops a sustained move, trend-following indicators can be enormously profitable and easy to use. The longer the trend, the fewer the signals and less trading involved.

http://www.stockcharts.com/education/What/IndicatorAnalysis/indicators2-print.html (4 of 6) [2/18/2003 5:22:51 AM]

StockCharts.com - Indicators Part 2

The benefits of trend-following indicators are lost when a security moves in a trading range. In the S&P 500 example, the index appears to have been range-bound at least 50% of the time. Even though the index trended higher from 1982 to 1999, there have also been large periods of sideways movement. From 1964 to 1980, the index traded within a large range bound by 85 and 110. Another drawback of trend-following indicators is that signals tend to be late. By the time a moving average crossover occurs, a significant portion of the move has already occurred. The Nov-98 buy signal occurred at 1130, about 19% above the Oct-98 low of 950. Late entry and exit points can skew the risk/reward ratio. The Challenge of Indicators

For technical indicators, there is a trade-off between sensitivity and consistency. In an ideal world, we want an indicator that is sensitive to price movements, gives early signals and has few false signals (whipsaws). If we increase the sensitivity by reducing the number of periods, an indicator will provide early signals, but the number of false signals will increase. If we decrease sensitivity by increasing the number of periods, then the number of false signals will decrease, but the signals will lag and and this will skew the reward-to-risk ratio. The longer a moving average is, the slower it will react and fewer signals will be generated. As the moving average is shortened, it becomes faster and more volatile, increasing the number of false signals. The same holds true for the various momentum indicators. A 14 period RSI will generate fewer signals than a 5 period RSI. The 5 period RSI will be much more sensitive and have more overbought and oversold readings. It is up to each investor to select a time frame that suits his or her trading style and objectives. In Part 3, we look at Oscillators in depth, and address the various methods used to generate buy and sell signals. Also, we analyze the mechanics of a very special oscillator that is neither a pure trend follower nor a leader, but part of both camps.

Written by Arthur Hill Part 1 | Part 2 | Part 3 | Part 4

Send us your Feedback!

http://www.stockcharts.com/education/What/IndicatorAnalysis/indicators2-print.html (5 of 6) [2/18/2003 5:22:51 AM]

StockCharts.com - Indicators Part 2

©2002 StockCharts.com All Rights Reserved Terms of Use

http://www.stockcharts.com/education/What/IndicatorAnalysis/indicators2-print.html (6 of 6) [2/18/2003 5:22:51 AM]

StockCharts.com - Indicators Part 3

Indicators Part 3

Oscillator Types

An oscillator is an indicator that fluctuates above and below a centerline or between set levels as its value changes over time. Oscillators can remain at extreme levels (overbought or oversold) for extended periods, but they cannot trend for a sustained period. In contrast, a security or a cumulative indicator like On-Balance-Volume (OBV) can trend as it continually increases or decreases in value over a sustained period of time.

As the indicator comparison chart shows, oscillator movements are more confined and http://www.stockcharts.com/education/What/IndicatorAnalysis/indicators3-print.html (1 of 11) [2/18/2003 5:23:06 AM]

StockCharts.com - Indicators Part 3

sustained movements (trends) are limited, no matter how long the time period. Over the two year period, Moving Average Convergence Divergence (MACD) fluctuated above and below zero, touching the zero line about twelve times. Also notice that each time MACD surpassed +80 the indicator pulled back. Even though MACD does not have an upper or lower limit on its range of values, its movements appear confined. OBV, on the other hand, began an uptrend in September 1998 and advanced steadily for the next year. Its movements are not confined and long-term trends can develop. There are many different types of oscillators and some belong to more than one category. The breakdown of oscillator types begins with two types: centered oscillators which fluctuate above and below a center point or line, and banded oscillators which fluctuate between overbought and oversold extremes. Generally, centered oscillators are best suited for analyzing the direction of price momentum, while banded oscillators are best suited for identifying overbought and oversold levels. Centered Oscillators Centered oscillators fluctuate above and below a central point or line. These oscillators are good for identifying the strength or weakness, or direction, of momentum behind a security's move. . In its purest form, momentum is positive (bullish) when a centered oscillator is trading above its center line and negative (bearish) when the oscillator is trading below its center line. MACD is an example of a centered oscillator that fluctuates above and below zero. MACD is the difference between the 12-day EMA and 26-day EMA of a security. The further one moving average moves away from the other, the higher the reading. Even though there is no range limit to MACD, extremely large differences between the two moving averages are unlikely to last for long. MACD is unique in that it has lagging elements as well as leading elements. Moving averages are lagging indicators and would be classified as trend-following or lagging elements. However, by taking the differences in the moving averages, MACD incorporates aspects of momentum or leading elements. The difference between the moving averages represents the rate of change. By measuring the rate-of-change, MACD becomes a leading indicator, but still with a bit of lag. With the integration of both moving averages and rate-of-change, MACD has forged a unique spot among oscillators as both a lagging and a leading indicator. Rate-of-change (ROC) is a centered oscillator that also fluctuates above and below zero. As its name implies, ROC measures the percentage price change over a given time period. For example: 20 day ROC would measure the percentage price change over the last 20 days. The bigger the difference between the current price and the price 20 days ago, the higher the value of the ROC Oscillator. When the indicator is above 0, the percentage price change is positive (bullish). When the indicator is below 0, the percentage price change is negative (bearish).

http://www.stockcharts.com/education/What/IndicatorAnalysis/indicators3-print.html (2 of 11) [2/18/2003 5:23:06 AM]

StockCharts.com - Indicators Part 3

ROC 20-period

As with MACD, ROC is not bound by upper or lower limits. This is typical of most centered oscillators and can make it difficult to spot overbought and oversold conditions. The ROC chart indicates that readings above +20% and below -20% represent extremes and are unlikely to last for an extended period of time. However, the only way to gauge that +20% and -20% are extreme readings is from past observations. Also, +20% and -20% represent extremes for this particular security and may not be the same for other securities. Banded oscillators offer a better alternative to gauge extreme price levels. Banded Oscillators Banded oscillators fluctuate above and below two bands that signify extreme price levels. The lower band represents oversold readings and the upper band represents overbought readings. These set bands are based on the oscillator and change little from security to security, allowing the users to easily identify overbought and oversold conditions. The Relative Strength Index (RSI) and the Stochastic Oscillator are two examples of banded oscillators. (Note: The formulas and rationale behind RSI and the Stochastic Oscillator are more complicated than those for MACD and ROC. As such, calculations are addressed in separate articles.) Stochastics/RSI

http://www.stockcharts.com/education/What/IndicatorAnalysis/indicators3-print.html (3 of 11) [2/18/2003 5:23:06 AM]

StockCharts.com - Indicators Part 3

For RSI, the bands for overbought and oversold are usually set at 70 and 30 respectively. A reading greater than 70 would be considered overbought and a reading below 30 would be considered oversold. For the Stochastic Oscillator, a reading above 80 is overbought and a reading below 20 oversold. Even though these are the recommended band settings, certain securities may not adhere to these ranges and might require more fine-tuning. Making adjustments to the bands is usually a judgment call that will reflect a trader's preferences and the volatility of the security. Many, but not all, banded oscillators fluctuate within set upper and lower limits. The Relative Strength Index (RSI) is range-bound by 0 and 100 and will never go higher than 100 nor lower than zero. The Stochastic Oscillator is another oscillator with a set range and is bound by 100 and 0 as well. However, the Commodity Channel Index (CCI) http://www.stockcharts.com/education/What/IndicatorAnalysis/indicators3-print.html (4 of 11) [2/18/2003 5:23:06 AM]

StockCharts.com - Indicators Part 3

is a banded oscillator that is not range bound. CCI

Conclusions Centered oscillators are best used to identify the underlying strength or direction of momentum behind a move. Broadly speaking, readings above the center point indicate bullish momentum and readings below the center point indicate bearish momentum. The biggest difference between centered oscillators and banded oscillators is the latter's ability to identify extreme readings. While it is possible to identify extreme readings with centered oscillators, they are not ideal for this purpose. Banded oscillators are best suited to identify overbought and oversold conditions. Oscillator Signals

Oscillators generate buy and sell signals in various ways. Some signals are geared towards early entry, while others appear after the trend has begun. In addition to buy and sell signals, oscillators can signal that something is amiss with the current trend or that the current trend is about to change. Even though oscillators can generate their own signals, it is important to use these signals in conjunction with other aspects of technical analysis. Most oscillators are momentum indicators and only reflect one characteristic of a security's price action. Volume, price patterns and support/resistance levels should also be taken into consideration. Positive and Negative Divergences http://www.stockcharts.com/education/What/IndicatorAnalysis/indicators3-print.html (5 of 11) [2/18/2003 5:23:06 AM]

StockCharts.com - Indicators Part 3

Divergence is a key concept behind many signals for oscillators as well as other indicators. Divergences can serve as a warning that the trend is about to change or set up a buy or sell signal. There are two types of divergences: positive and negative. In its most basic form, a positive divergence occurs when the indicator advances and the underlying security declines. A negative divergence occurs when an indicator declines and the underlying security advances. Merrill Lynch

On the Merrill Lynch (MER) chart, MACD formed a positive divergence in late October. While MER was trading below its previous reaction low, MACD had yet to penetrate its previous low (green arrows). However, MACD had not turned up and the positive divergence was still just a possibility. When MACD turned up and traded above its 9-day http://www.stockcharts.com/education/What/IndicatorAnalysis/indicators3-print.html (6 of 11) [2/18/2003 5:23:06 AM]

StockCharts.com - Indicators Part 3

EMA, a positive divergence was confirmed. At this point, other signals came together to create a buy signal. Not only had the stock reached support and gapped up, but there was also a MACD positive divergence and a MACD bullish crossover. (Note: The thick line and the thin line is the 9-day EMA of MACD, which acts as a trigger line. A bullish crossover occurs when MACD moves above its 9-day EMA and a bearish crossover occurs when MACD moves below its 9-day EMA.) After these MACD signals, the stock gapped up the very next day on a huge increase in volume. Intel

On the Intel (INTC) chart, the ROC Oscillator formed a negative divergence just prior to the decline that began in September. When INTC recorded a record high in early September, the ROC Oscillator failed to surpass its previous high. The stock then began to decline and the ROC Oscillator turned lower as well, thus completing the lower high and the negative divergence. As there was little else to go on at the time, this negative divergence should have been taken as a warning signal. However, when the ROC Oscillator continued to deteriorate and broke below 0 (centerline), it was clear that the stock was weak and vulnerable to a further decline. Overbought and Oversold Extremes

Banded oscillators are designed to identify overbought and oversold extremes. Since these oscillators fluctuate between extremes, they can be difficult to use in trending markets. Banded oscillators are best used in trading ranges or with securities that are not trending. In a strong trend, users may see many signals that are not really valid. If http://www.stockcharts.com/education/What/IndicatorAnalysis/indicators3-print.html (7 of 11) [2/18/2003 5:23:06 AM]

StockCharts.com - Indicators Part 3

a stock is in a strong uptrend, buying on oversold conditions will work much better than selling on overbought conditions. In a strong trend, oscillator signals against the direction of the underlying trend are less robust than those with the trend. The trend is your friend and can be dangerous to fight it. Even though securities develop trends, they also fluctuate within those trends. If a stock is in a strong uptrend, buying when oscillators reach oversold conditions (and near support tests) will work much better than selling on overbought conditions. During a strong downtrend, selling when oscillators reach overbought conditions would work much better. If the path of least resistance is up (down), then acting on only bullish (bearish) signals would be in harmony with the trend. Attempts to trade against the trend carry added risk. When the trend is strong, banded oscillators can remain near overbought or oversold levels for extended periods. An overbought condition does not indicate that it is time to sell, nor does an oversold condition indicate that it is time to buy. In a strong uptrend, an oscillator can reach an overbought condition and remain so as the underlying security continues to advance. A negative divergence may form, but a bearish signal against the uptrend should be considered suspect. In a strong downtrend, an oscillator can reach an oversold condition and remain so as the underlying security continues to decline. Similarly, a positive divergence may form, but a bullish signal against the downtrend should be considered suspect. This does not mean counter-trend signals won't work, but they should be viewed in proper context and considered with other aspects of technical analysis. The first step in using banded oscillators is to identify the upper and lower bands that mark the extremities. For RSI, anything below 30 and above 70 represents an extremity. For the Stochastic Oscillator, anything below 20 and above 80 represents an extremity. We know that when RSI is below 30 or the Stochastic Oscillator is below 20, an oversold condition exists. By that same token, when RSI is above 70 and the Stochastic Oscillator is above 80, an overbought condition exists. Identification of an overbought or oversold condition should serve as an alert to monitor other technical aspects (price pattern, trend, support, resistance, candlesticks, volume or other indicators) with extra vigilance. The simplest method to generate signals is to note when the upper and lower bands are crossed. If a security is overbought (above 70 for RSI and 80 for the Stochastic Oscillator) and moves back down below the upper band, then a sell signal is generated. If a security is oversold (below 30 for RSI and 20 for the Stochastic Oscillator) and moves back above the lower band, then a buy signal is generated. Keep in mind that these are the simplest methods. Simple signals can also be combined with divergences and moving average crossovers to create more robust signals. Once a stock becomes oversold, traders may look for a positive divergence to develop in the RSI and then a cross above 30. With the

http://www.stockcharts.com/education/What/IndicatorAnalysis/indicators3-print.html (8 of 11) [2/18/2003 5:23:06 AM]

StockCharts.com - Indicators Part 3

Stochastic Oscillator overbought, traders may look for a negative divergence and combine that with a moving average crossover and a break below 80 to generate a signal. (Note: The Stochastic Oscillator is usually plotted with a 3-day simple moving average that acts as the trigger line. When the Stochastic Oscillator crosses above the trigger line it is a bullish moving average crossover, and when it crosses below it is bearish). Cisco

The Cisco (CSCO) chart shows that the Stochastic Oscillator can change from oversold to overbought quite quickly. Much depends on the number of time periods used to calculate the oscillator. A 10-day Slow Stochastic Oscillator will be more volatile than a 20-day. The thin green lines indicate when the Stochastic Oscillator touched or crossed http://www.stockcharts.com/education/What/IndicatorAnalysis/indicators3-print.html (9 of 11) [2/18/2003 5:23:06 AM]

StockCharts.com - Indicators Part 3

the oversold line at 20. The thin red lines indicate when Stochastic Oscillator touched or crossed the overbought line. CSCO was in a strong up trend at the time and experiencing little selling pressure. Therefore, trying to sell when the oscillator crossed back below 80 would have been against the uptrend and not the proper strategy. When a security is trending up or has a bullish bias, traders would be better off looking for oversold conditions to generate buying opportunities. We can also see that much of the upside for the stock occurred after the Stochastic Oscillator advanced above 80 (thin red lines). The green circle in August shows a buy signal that was generated with three separate items: one, the oscillator moved above 20 from oversold conditions; two, the oscillator moved above its 3-day MA; and three, the oscillator formed a positive divergence. Confirmation from these three items makes for a more robust signal. After the buy signal, the oscillator was in overbought territory a mere 4 days later. However, the stock continued its advance for 2-3 weeks before reaching its high. Airborne Freight

http://www.stockcharts.com/education/What/IndicatorAnalysis/indicators3-print.html (10 of 11) [2/18/2003 5:23:06 AM]

StockCharts.com - Indicators Part 3

The Airborne Freight (ABF) chart reveals trading opportunities with the Relative Strength Index (RSI). Because a 14-period RSI rarely moved below 30 and above 70, a 10-period RSI was chosen to increase sensitivity. With the intermediate-term and longterm trends decidedly bearish, savey traders could have sold short each time RSI reached overbought (black vertical lines). More aggressive traders could have played the long side each time RSI dipped below 30 and then moved back above this oversold level. The first two buy signals were generated with a positive divergence and a move above 30 from oversold conditions. The third buy signal came after RSI briefly dipped below 30. Keep in mind that these three signals were against the larger downtrend and trading strategies should be adjusted accordingly.

Written by Arthur Hill Part 1 | Part 2 | Part 3 | Part 4

Send us your Feedback!

©2002 StockCharts.com All Rights Reserved Terms of Use

http://www.stockcharts.com/education/What/IndicatorAnalysis/indicators3-print.html (11 of 11) [2/18/2003 5:23:06 AM]

StockCharts.com - Indicators Part 4

Indicators Part 4

Centerline Crossovers

As the name implies, centerline crossover signals apply mainly to centered oscillators that fluctuate above and below a centerline. Traders have been also known to use centerline crosses with RSI in order validate a divergence or signal generated from an overbought or oversold reading. However, most banded oscillators, such as RSI and Stochastics, rely on divergences and overbought/oversold levels to generate signals. The middle ground is a bit of a no man's land for banded oscillators and is probably best left to other tools. For our purposes, the analysis of centerline crossovers will focus on centered oscillators such as Chaikin Money Flow, MACD and Rate-of-Change (ROC). A centerline crossover is sometimes interpreted as a buy or sell signal. A buy signal would be generated with a cross above the centerline and a sell signal with a cross below the centerline. For MACD or ROC, a cross above or below zero would act as a signal. Movements above or below the centerline indicate that momentum has changed from either positive to negative or negative to positive. When a centered momentum oscillator advances above its centerline, momentum turns positive and could be considered bullish. When a centered momentum oscillator declines below its centerline, momentum turns negative and could be considered bearish. Intel

http://www.stockcharts.com/education/What/IndicatorAnalysis/indicators4-print.html (1 of 6) [2/18/2003 5:23:18 AM]

StockCharts.com - Indicators Part 4

On this Intel chart with MACD and ROC, there have been a number of signals generated from the centerline crossover. There were a couple of excellent signals, but there were also plenty of false signals and whipsaws. This highlights some of the challenges associated with trading oscillator signals. Also, it stresses the importance of combining various signals in order to create more robust buy and sell signals. Some traders also criticize centerline crossover signals as being too late and missing too much of the move. A centerline crossover can also act as a confirmation signal to validate a previous signal or reinforce the current trend. If there were a positive divergence and bullish moving average crossover, then a subsequent advance above the centerline would confirm the previous buy signal. Failure of the oscillator to move above the centerline could be seen http://www.stockcharts.com/education/What/IndicatorAnalysis/indicators4-print.html (2 of 6) [2/18/2003 5:23:18 AM]

StockCharts.com - Indicators Part 4

as a non-confirmation and act as an alert that something was amiss. Intel

On the Intel chart with MACD, the centerline crossover acts as the third in a series of bullish signals. Even after the third signal, Intel still has plenty of upside left. 1. There was the higher low forming that signaled a potential positive divergence. 2. There was the bullish moving average crossover to confirm the positive divergence. 3. And finally, there was the bullish centerline crossover. Some traders would worry about missing too much of the move by waiting for the third http://www.stockcharts.com/education/What/IndicatorAnalysis/indicators4-print.html (3 of 6) [2/18/2003 5:23:18 AM]

StockCharts.com - Indicators Part 4

and final confirmation. However, this can be a more reliable signal and help to avoid whipsaws and false signals. It is true that waiting for the third signal will reduce profits, but it can also help reduce risk. IBM

Chaikin Money Flow is an example of a centered oscillator that places importance on crosses above and below the centerline. Divergences, overbought levels and oversold levels are all secondary to the absolute level of the indicator. The direction of the oscillator's movement is important, but needs to be placed in the context of the absolute level. The longer the oscillator is above zero, the more evidence of accumulation. The longer the oscillator is below zero, the more evidence of distribution. Hence, Chaikin Money Flow is considered to be bullish when the oscillator is trading http://www.stockcharts.com/education/What/IndicatorAnalysis/indicators4-print.html (4 of 6) [2/18/2003 5:23:18 AM]

StockCharts.com - Indicators Part 4

above zero and bearish when trading below zero. On the IBM chart, Chaikin Money Flow began to turn down in July. At this time, the stock was declining with the market and the decline in the oscillator was normal. However, in the second half of August, concerns began to grow when the oscillator failed to continue up with the stock and fell below zero. As the stock advanced further, Chaikin Money Flow continued to deteriorate. This served as a signal that something was amiss. Oscillator Signals - Conclusions

Banded oscillators are best used to identify overbought and oversold conditions. However, overbought is not meant to act a sell signal and oversold is not meant to act as a buy signal. Overbought and oversold situations serve as an alert that conditions are reaching extreme levels and close attention should be paid to the price action and other indicators. To improve the robustness of oscillator signals, traders can look for multiple signals. The criteria for a buy or sell signal could depend on three separate yet confirming signals. A buy signal might be generated with an oversold reading, positive divergence and bullish moving average crossover. Conversely, a sell signal might be generated from a negative divergence, bearish moving average crossover and bearish centerline crossover. Traditional chart pattern analysis can also be applied to oscillators. This is a bit trickier, but can help to identify the strength behind an oscillator's move. Looking for higher highs or lower lows can help confirm previous analysis. A trendline breakout can signal that a change in the direction of the momentum is imminent. It is dangerous to trade an oscillator signal against the major trend of the market. In bull moves, it is best to look for buying opportunities through oversold signals, positive divergences, bullish moving average crossovers and bullish centerline crossovers. In bear moves, it is best to look for selling opportunities through overbought signals, negative divergences, bearish moving average crossovers and bearish centerline crossovers. And finally, oscillators are most effective when used in conjunction with pattern analysis, support/resistance identification, trend identification and other technical analysis tools. By being aware of the broader picture, oscillator signals can be put into context. It is important to identify the current trend or even to ascertain if the security is trending at all. Oscillator readings and signals can have different meaning in differing circumstances. By using other analysis techniques in conjunction with oscillator reading, the chances of success can be greatly enhanced.

http://www.stockcharts.com/education/What/IndicatorAnalysis/indicators4-print.html (5 of 6) [2/18/2003 5:23:18 AM]

StockCharts.com - Indicators Part 4

Written by Arthur Hill Part 1 | Part 2 | Part 3 | Part 4

Send us your Feedback!

©2002 StockCharts.com All Rights Reserved Terms of Use

http://www.stockcharts.com/education/What/IndicatorAnalysis/indicators4-print.html (6 of 6) [2/18/2003 5:23:18 AM]

StockCharts.com - Accumulation/Distribution Line

Accumulation/Distribution Line

Introduction - Volume and the Flow of Money

There are many indicators available to measure volume and the flow of money for a particular stock, index or security. One of the most popular volume indicators over the years has been the Accumulation/Distribution Line. The basic premise behind volume indicators, including the Accumulation/Distribution Line, is that volume precedes price. Volume reflects the amount of shares traded in a particular stock and is a direct reflection of the money flowing into and out of a stock. Many times before a stock advances, there will be period of increased volume just prior to the move. Most volume or money flow indicators are designed to identify early increases in positive or negative volume flow to gain an edge before the price moves. (Note: the terms "money flow" and "volume flow" are essentially interchangeable.) Methodology

(Click here to see a live example of the Acc/Dist Line) The Accumulation/Distribution Line was developed by Marc Chaikin to assess the cumulative flow of money into and out of a security. In order to fully appreciate the methodology behind the Accumulation/Distribution Line, it may be helpful to examine one of the earliest volume indicators and see how it compares. In 1963, Joe Granville developed On Balance Volume (OBV), which was one of the earliest and most popular indicators to measure positive and negative volume flow. OBV is a relatively simple indicator that adds the corresponding period's volume when the close is up and subtracts it when the close is down. A cumulative total of the positive and negative volume flow (additions and subtractions) forms the OBV line. This line can then be compared with the price chart of the underlying security to look for divergences or confirmation. In developing the Accumulation/Distribution Line, Chaikin took a different approach. OBV uses the change in closing price from one period to the next to value the volume as positive or negative. Even if a stock opened on the low and closed on the high, the period's OBV value would be negative as long as the close was lower than the previous period's close. Chaikin choose to ignore the change from one period to the next and instead focused on the price action for a given period (day, week, month). He derived a http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_AccumDistLine-print.html (1 of 9) [2/18/2003 5:23:33 AM]

StockCharts.com - Accumulation/Distribution Line

formula to calculate a value based on the location of the close, relative to the range for the period. We will call this value the "Close Location Value" or CLV. The CLV ranges from plus one to minus one with the center point at zero. There are basically five combinations:

1. If the stock closes on the high, the absolute top of the range, then the value would be plus one. 2. If the stock closes above the midpoint of the high-low range, but below the high, then the value would be between zero and one. 3. If the stock closes exactly halfway between the high and the low, then the value would be zero. 4. If the stock closes below the midpoint of the high-low range, but above the low, then the value would be negative. 5. If the stock closes on the low, the absolute bottom of the range, then the value would be minus one. The CLV is then multiplied by the corresponding period's volume and the cumulative total forms the Accumulation/Distribution Line. Ciena

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_AccumDistLine-print.html (2 of 9) [2/18/2003 5:23:33 AM]

StockCharts.com - Accumulation/Distribution Line

The daily chart of CIEN gives a breakdown of the Accumulation/Distribution Line and shows how different closing levels affect the value. The top section shows the price chart for CIEN. The closing level relative to the high-low range is clearly visible. The second section with a black histogram is the Closing Location Value (CLV). The CLV is multiplied by volume and the result appears in the green histogram. Finally, at the bottom, is the Accumulation/Distribution Line. 1. The close is on the low and the CLV = -1. Volume, however, was relatively light and the Accumulation/Distribution Value for that period is only moderately negative. 2. The close is very near the high and the CLV = +.9273. Volume is relatively high and the resulting Accumulation/Distribution Value is high. http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_AccumDistLine-print.html (3 of 9) [2/18/2003 5:23:33 AM]

StockCharts.com - Accumulation/Distribution Line

3. The close is near the low and the CLV = -.75. Volume is moderately high and the resulting Accumulation/Distribution Value is moderately high as well. 4. The close is about half way between the mid-point of the high-low range and the high, and the CLV = +.51. Volume is very heavy and the Accumulation/Distribution Value is also very high. Accumulation/Distribution Line Signals

The signals for the Accumulation/Distribution Line are fairly straightforward and center around the concepts of divergence and confirmation. Bullish Signals

A bullish signal is given when the Accumulation/Distribution Line forms a positive divergence. Be wary of weak positive divergences that fail to make higher reaction highs or those that are relatively young. The main issue is to identify the general trend of the Accumulation/Distribution Line. A two-week positive divergence may be a bit suspect. However, a multi-month positive divergence deserves serious attention. Alcoa

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_AccumDistLine-print.html (4 of 9) [2/18/2003 5:23:33 AM]

StockCharts.com - Accumulation/Distribution Line

On the chart for AA, the Accumulation/Distribution Line formed a huge positive divergence that was over 4 months in the making. Even though the stock fell from above 35 to below 30, the Accumulation/Distribution Line continued on a relentless march north. If one did not know better, it would seem that the two plots did not belong together. However, the stock finally caught up with the Accumulation/Distribution Line when it broke resistance in November. Another means of using the Accumulation/Distribution Line is to confirm the strength or sustainability behind an advance. In a healthy advance, the Accumulation/Distribution Line should keep up or at the very least move in an uptrend. If the stock is moving up at a rapid clip, but the Accumulation/Distribution Line has trouble making higher highs or trades sideways, it should serve as an indication that buying pressure is relatively weak. Walmart

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_AccumDistLine-print.html (5 of 9) [2/18/2003 5:23:33 AM]

StockCharts.com - Accumulation/Distribution Line

WMT began a sharp advance in August that was accompanied by an equally strong move in the Accumulation/Distribution Line. In fact, the Accumulation/Distribution Line was stronger than the stock in early September. After a bit of a consolidation, both again started higher and recorded new reaction highs in early October. Volume flows were behind this advance from the very beginning and continued throughout. The stock ended up advancing from 40 to 60 in about 3 months. Interestingly, as of this writing (December 1999) the Accumulation/Distribution Line has started to move sideways and is indicating that buying pressure is beginning to wane. Bearish Signals

The same principles that apply to positive divergences apply to negative divergences. The key issue is to identify the main trend in the Accumulation/Distribution Line and compare it to the underlying security. Young negative divergences, or those that are relatively flat, should be looked upon with a healthy dose of skepticism. The WMT chart shows a relatively flat negative divergence that is just over a month old. This negative divergence has yet to make a lower low and should probably be given a http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_AccumDistLine-print.html (6 of 9) [2/18/2003 5:23:33 AM]

StockCharts.com - Accumulation/Distribution Line

little more time to mature. The relative weakness in the Accumulation/Distribution Line should serve as a sign that buying pressure is diminishing while the stock remains at lofty levels. Delta Airlines

The DAL chart shows a negative divergence that developed within the confines of a clear downtrend. The stock had clearly broken down and the Accumulation/Distribution Line was declining in line with the stock. A deteriorating Accumulation/Distribution Line confirmed weakness in the stock. During the June-July rally, the stock recorded a new reaction high, but the Accumulation/Distribution Line failed, thus setting up the negative divergence. Conclusions

The Accumulation/Distribution Line is good means to measure the volume force behind a move.

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_AccumDistLine-print.html (7 of 9) [2/18/2003 5:23:33 AM]

StockCharts.com - Accumulation/Distribution Line

1. As a volume indicator, the Accumulation/Distribution Line will help to determine if the volume in a security is increasing on the advances or declines. 2. The Accumulation/Distribution Line can be used to gauge the general flow of money. An uptrend indicates that buying pressure is prevailing and a downtrend indicates that selling pressure is prevailing. 3. The Accumulation/Distribution Line can be used to spot divergences, both positive and negative 4. The Accumulation/Distribution Line can be used to confirm the strength and sustainability behind a move. There are some drawbacks to the Accumulation/Distribution Line, though. 1. The indicator does not take gaps into consideration. A stock that gaps up and closes midway between the high and the low will not receive any credit for the advance off of the gap. A series of gaps could go largely undetected. 2. Because the Accumulation/Distribution Line is clearly tied to price movement, specifically the close, it will sometimes move in step with the underlying security and yield few divergences. 3. It sometimes difficult to detect subtle changes in volume flows. The rate of change in a downtrend could be slowing, but it may be impossible to detect until the Accumulation/Distribution Line turns up. This drawback has been addressed in the form of the Chaikin Oscillator or Chaikin Money Flow, which are next in the education series. SharpCharts application

The Accumulation/Distribution Line can be set as an indicator above or below a security's price plot. Because it is a cumulative indicator based on each individual period (day, week or month), there are no settings to adjust in the boxes to the right. By default, a 20-period EMA is included with the indicator. Generally, the indicator is strengthening while above the 20-period EMA and weakening while below.

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_AccumDistLine-print.html (8 of 9) [2/18/2003 5:23:33 AM]

StockCharts.com - Accumulation/Distribution Line

The next article in this education series examines the method and the madness behind the Chaikin Money Flow Oscillator.

Written by Arthur Hill

Send us your Feedback!

©2002 StockCharts.com All Rights Reserved Terms of Use

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_AccumDistLine-print.html (9 of 9) [2/18/2003 5:23:33 AM]

StockCharts.com - Average Directional Index (ADX)

Average Directional Index (ADX) J. Welles Wilder Jr. developed the Average Directional Index (ADX) in order to evaluate the strength of the current trend, be it up or down. It's important to detemine whether the market is trending or trading (moving sideways), because certain indicators give more useful results depending on the market doing one or the other. ADX is an oscillator that fluctuates between 0 and 100. Even though the scale is from 0 to 100, readings above 60 are relatively rare. Low readings, below 20, indicate a weak trend and high readings, above 40, indicate a strong trend. The indicator does not grade the trend as bullish or bearish, but merely assesses the strength of the current trend. A reading above 40 can indicate a strong downtrend as well as a strong uptrend. ADX can also be used to identify potential changes in a market from trending to nontrending. When ADX begins to strengthen from below 20 and/or moves above 20, it is a sign that the trading range is ending and a trend could be developing.

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_ADX-print.html (1 of 4) [2/18/2003 5:23:43 AM]

StockCharts.com - Average Directional Index (ADX)

(Click here to see a live example of ADX) When ADX begins to weaken from above 40 and/or moves below 40, it is a sign that the current trend is losing strength and a trading range could develop.

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_ADX-print.html (2 of 4) [2/18/2003 5:23:43 AM]

StockCharts.com - Average Directional Index (ADX)

ADX is derived from two other indicators, also developed by Wilder, called the Positive Directional Indicator (sometimes written +DI) and the Negative Directional Indicator (DI). More on ADX can be found in Wilder's book, New Concepts In Technical Trading Systems, written in 1978. Wilder's indicators remain some of the best and most popular indicators today.

Written by Arthur Hill

Send us your Feedback!

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_ADX-print.html (3 of 4) [2/18/2003 5:23:43 AM]

StockCharts.com - Average Directional Index (ADX)

©2002 StockCharts.com All Rights Reserved Terms of Use

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_ADX-print.html (4 of 4) [2/18/2003 5:23:43 AM]

StockCharts.com - Average True Range (ATR)

Average True Range (ATR) Developed by J. Welles Wilder and introduced in his book, New Concepts in Technical Trading Systems (1978), the Average True Range (ATR) indicator measures a security's volatility. As such, the indicator does not provide an indication of price direction or duration, simply the degree of price movement or volatility. As with most of his indicators, Wilder designed ATR with commodities and daily prices in mind. In 1978, commodities were frequently more volatile than stocks. However, recent Nasdaq price action may belie that notion. In addition, commodities were (and still are) often subject to gaps and limit moves. A limit move occurs when a commodity opens up or down its maximum allowed move and does not trade again until the next session. The resulting bar or candlestick would simply be a small dash. In order to accurately reflect the volatility associated with commodities, Wilder sought to account for gaps, limit moves and small high/low ranges in his calculations. A volatility formula based on only the high/low range would fail to capture the actual volatility created by the gap or limit move. Wilder defined the true range (TR) as the greatest of the following: ● ● ●

The current high less the current low. The absolute value of: current high less the previous close. The absolute value of: current low less the previous close.

If the current high/low range is large, chances are it will be used as the TR. If the current high/low range is small, it is likely that one of the other two methods would be used to calculate the TR. The last two possibilities usually arise when the previous close is greater than the current high (signaling a potential gap down and/or limit move) or the previous close is lower than the current low (signaling a potential gap up and/or limit move). To ensure positive numbers, absolute values were applied to differences.

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_ATR-print.html (1 of 6) [2/18/2003 5:23:57 AM]

StockCharts.com - Average True Range (ATR)

The example above shows three potential situations when the TR would not be based on the current high/low range. Notice that all three examples have small high/low ranges and two examples show a significant gap. A. A small high/low range formed after a gap up. The TR was found by calculating the absolute value of the difference between the current high and the previous close. B. A small high/low range formed after a gap down. The TR was found by calculating the absolute value of the difference between the current low and the previous close. C. Even though the current close is within the previous high/low range, the current high/low range is quite small. In fact, it is smaller than the absolute value of the difference between the current high and the previous close, which is used to value the TR. Typically, the Average True Range (ATR) is based on 14 periods and can be calculated on an intraday, daily, weekly or monthly basis. For this example, the ATR will be based on daily data. Because there must be a beginning, the first TR value in a series is simply the high minus the low and the first 14-day ATR is found by averaging the daily ATR values for the last 14 days. After that, Wilder sought to smooth the data set, by incorporating the previous period's ATR value. The second and subsequent 14-day ATR value would be calculated with the following steps: 1. Multiply the previous 14-day ATR by 13. 2. Add the most recent day's TR value. 3. Divide by 14.

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_ATR-print.html (2 of 6) [2/18/2003 5:23:57 AM]

StockCharts.com - Average True Range (ATR)

In the Excel spread sheet example above, the first TR value (1.9688) equals the high minus the low. The first 14-day ATR value (3.6646) was calculated by finding the average of first 14 TR values. The second ATR value started the smoothing process by using the previous value.

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_ATR-print.html (3 of 6) [2/18/2003 5:23:57 AM]

StockCharts.com - Average True Range (ATR)

The chart above corresponds with the Excel spreadsheet calculations for Sun Microsystems from 23-Oct 2000 to 7-Dec 2000. ● ●

Day 15: (( 3.6646 x 13 ) + 4.3437 ) / 14 = 3.7131 Day 16: (( 3.7131 x 13 ) + 4.2812 ) / 14 = 3.7536

For those trying this at home, here are a few cautionary notes on calculations. ●

●

●

●

There is always a beginning and the first calculations may not conform exactly with the formula. The first TR value is simply the high minus the low and the first ATR is a simple average of the first 14 TR values. Second, many indicators involve a smoothing process. In this example, the previous period's ATR is used to form the current ATR. This example only contains a small portion of total available price data. The size of the data set will affect the final outcome. Although the difference is not likely to be huge, a data set of 33 days will produce a different ATR value than a data set of 500 days. If you wish to replicate this formula, first try and duplicate the example provided using the

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_ATR-print.html (4 of 6) [2/18/2003 5:23:57 AM]

StockCharts.com - Average True Range (ATR)

●

same open/high/low/close data. Once your formulas produce answers that match the example, you can then plug in your desired open/high/low/close data. Due to rounding issues and decimal places, an exact match may not be possible. Also, discrepancies in the open/high/low/close data can produce different indicator values.

Example: The IBM chart provides an example of the 14-day ATR in action. Extreme levels (both high and low) can mark turning points or the beginning of a move. As a volatility-based indicator like Bollinger Bands, the ATR cannot predict direction or duration, simply activity levels. Low levels indicate quiet trading (small ranges) and high levels indicate violent trading (large ranges). A prolonged period of low ATR readings might indicate consolidation and the beginning of a continuation move or reversal. High ATR readings usually result from a sharp advance or decline and are unlikely to be sustained for extended periods.

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_ATR-print.html (5 of 6) [2/18/2003 5:23:57 AM]

StockCharts.com - Average True Range (ATR)

SharpChart Application: Using SharpCharts, the ATR can be set as an indicator above or below a security's price plot. The only variable necessary is the number of periods and the first box to the right can be used to make adjustments. The default setting is 14 periods and the indicator can be used on intraday, daily, weekly or monthly charts. The scale is set in absolute (not percentage) price increments based on price changes in the selected security. The lower the price is, the smaller the scale on the ATR. Special note: Because the ATR shows volatility as an absolute level (versus percentage), low price stocks will have lower ATR levels than high price stocks. For example, a $10 security would have a much lower ATR reading than a $200 stock. Because of this, ATR readings can be difficult to compare across a range of securities. Even for a single security, large price movements, such as a decline from 70 to 20, can make long-term ATR comparisons problematical.

Written by Arthur Hill

Send us your Feedback!

©2002 StockCharts.com All Rights Reserved Terms of Use

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_ATR-print.html (6 of 6) [2/18/2003 5:23:57 AM]

StockCharts.com - Bollinger Bands

Bollinger Bands

Overview

Developed by John Bollinger, Bollinger Bands are an indicator that allows users to compare volatility and relative price levels over a period time. The indicator consists of three bands designed to encompass the majority of a security's price action. 1. A simple moving average in the middle 2. An upper band (SMA plus 2 standard deviations) 3. A lower band (SMA minus 2 standard deviations) Standard deviation is a statistical term that provides a good indication of volatility. Using the standard deviation ensures that the bands will react quickly to price movements and reflect periods of high and low volatility. Sharp price increases (or decreases), and hence volatility, will lead to a widening of the bands.

Formula

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_Bbands-print.html (1 of 9) [2/18/2003 5:24:11 AM]

StockCharts.com - Bollinger Bands

IBM

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_Bbands-print.html (2 of 9) [2/18/2003 5:24:11 AM]

StockCharts.com - Bollinger Bands

(Click here to see a live example of Bollinger Bands)

The centerline is the 20-day simple moving average. The upper band is the 20-day simple moving average plus 2 standard deviations. The lower band is the 20-day simple moving average less 2 standard deviations. Settings

Closing prices are most often used to compute Bollinger Bands. Other variations, including typical and weighted prices, can also be used. ●

Typical Price = (high + low + close)/3

●

Weighted Price = (high + low + close + close)/4

Bollinger recommends using a 20-day simple moving average for the center band and 2 standard deviations for the outer bands. The length of the moving average and number of deviations can be adjusted to better suit individual preferences and specific characteristics of a security. Trial and error is one method to determine an appropriate moving average length. A simple visual assessment can be used to determine the appropriate number of periods. http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_Bbands-print.html (3 of 9) [2/18/2003 5:24:11 AM]

StockCharts.com - Bollinger Bands

Bollinger Bands should encompass the majority of price action, but not all. After sharp moves, penetration of the bands is normal. If prices appear to penetrate the outer bands too often, then a longer moving average may be required. If prices rarely touch the outer bands, then a shorter moving average may be required. A more exact method to determine moving average length is by matching it with a reaction low after a bottom. For a bottom to form and a downtrend to reverse, a security needs to form a low that is higher than the previous low. Properly set Bollinger Bands should hold support established by the second (higher) low. If the second low penetrates the lower band, then the moving average is too short. If the second low remains above the lower band, then the moving average is too long. The same logic can be applied to peaks and reaction rallies. The upper band should mark resistance for the first reaction rally after a peak. Walmart

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_Bbands-print.html (4 of 9) [2/18/2003 5:24:11 AM]

StockCharts.com - Bollinger Bands

For WMT, a 20-period simple moving average proved to be a bit too long for the Bollinger Bands. Notice the wide gap between the lower band and the higher low in March. Through trial and error, a 12-period simple moving average appears to offer a better fit. For general timeframes, Bollinger recommends a 10-day moving average for the short term, a 20-day moving average for the intermediate term and 50-day moving average for the long term. Use

In addition to identifying relative price levels and volatility, Bollinger Bands can be combined with price action and other indicators to generate signals and foreshadow significant moves. Double bottom buy: A double bottom buy signal is given when prices penetrate the lower band and remain above the lower band after a subsequent low forms. Either low can be higher or lower than the other. The important thing is that the second low remains above the lower band. The bullish setup is confirmed when the price moves above the middle band, or simple moving average. AT&T

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_Bbands-print.html (5 of 9) [2/18/2003 5:24:11 AM]

StockCharts.com - Bollinger Bands

T provides an example of a double bottom buy signal. The stock penetrated the lower band in late September (red arrow) and then held above on the subsequent test in October. The October breakout above the middle band (green circle) provided the bullish confirmation. Double top sell: A sell signal is given when prices peak above the upper band and a subsequent peak fails to break above the upper band. The bearish setup is confirmed when prices decline below the middle band. Sharp price changes can occur after the bands have tightened and volatility is low. In this instance, Bollinger Bands do not give any hint as to the future direction of prices. Direction must be determined using other indicators and aspects of technical analysis. Many securities go through periods of high volatility followed by periods of low volatility. Using Bollinger Bands, these periods can be easily identified with a visual assessment. Tight bands indicate low volatility and wide bands indicate high volatility. Volatility can be important for options players because options prices will be cheaper when volatility is low. Starbucks

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_Bbands-print.html (6 of 9) [2/18/2003 5:24:11 AM]

StockCharts.com - Bollinger Bands

SBUX provides an example of the bands tightening before a big move. In November, the bands were relatively wide and began to tighten over the next 2 months. By early January, the bands were the tightest in over 4 months (red circle). A little over a week later, the stock exploded for a 10+ point gain in less than 2 weeks. Conclusions

Even though Bollinger Bands can help generate buy and sell signals, they are not designed to determine the future direction of a security. The bands were designed to augment other analysis techniques and indicators. By themselves, Bollinger Bands serve two primary functions: ●

●

To identify periods of high and low volatility To identify periods when prices are at extreme, and possibly unsustainable, levels.

As stated above, securities can fluctuate between periods of high volatility and low volatility. Being able to identify a period of low volatility can serve as an alert to monitor the price action of a security. Other aspects of technical analysis, such as momentum, moving averages and retracements, can then be employed to help determine the direction of the potential breakout. Remember that buy and sell signals are not given when prices reach the upper or lower http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_Bbands-print.html (7 of 9) [2/18/2003 5:24:11 AM]

StockCharts.com - Bollinger Bands

bands. Such levels merely indicate that prices are high or low on a relative basis. A security can become overbought or oversold for an extended period of time. Knowing whether or not prices are high or low on a relative basis can enhance our interpretation of other indicators and assist with timing issues in trading.

SharpChart Application

As a SharpChart indicator, Bollinger Bands can be found in the price overlays section. The first box sets the number of days for the simple moving average, which is the middle band. The second box sets the number of standard deviations above and below the simple moving average to set the upper and lower bands. The default setting is a 20day simple moving average with the upper and lower bands set 2 standard deviations above and below. Both settings can be changed and users are encouraged to experiment. Starbucks

Sometimes when using the log scale, the lower band will exceed the price scale and become cut off. To alleviate this, change the scale setting from "log" to "linear."

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_Bbands-print.html (8 of 9) [2/18/2003 5:24:11 AM]

StockCharts.com - Bollinger Bands

Written by Arthur Hill

Send us your Feedback!

©2002 StockCharts.com All Rights Reserved Terms of Use

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_Bbands-print.html (9 of 9) [2/18/2003 5:24:11 AM]

StockCharts.com - Commodity Channel Index (CCI)

Commodity Channel Index (CCI) Developed by Donald Lambert, the Commodity Channel Index (CCI) was designed to identify cyclical turns in commodities. The assumption behind the indicator is that commodities (or stocks or bonds) move in cycles, with highs and lows coming at periodic intervals. Lambert recommended using 1/3 of a complete cycle (low to low or high to high) as a time frame for the CCI. (Note: Determination of the cycle's length is independent of the CCI.) If the cycle runs 60 days (a low about every 60 days), then a 20-day CCI would be recommended. For the purpose of this example, a 20-day CCI is used. There are 4 steps involved in the calculation of the CCI: 1. Calculate the last period's Typical Price (TP) = (H+L+C)/3 where H = high, L = low, and C = close. 2. Calculate the 20-period Simple Moving Average of the Typical Price (SMATP). 3. Calculate the Mean Deviation. First, calculate the absolute value of the difference between the last period's SMATP and the typical price for each of the past 20 periods. Add all of these absolute values together and divide by 20 to find the Mean Deviation. 4. The final step is to apply the Typical Price (TP), the Simple Moving Average of the Typical Price (SMATP), the Mean Deviation and a Constant (.015) to the following formula:

(Click here to download an Excel spreadsheet that contains a example of the CCI being calculated.) DELL

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_CCI-print.html (1 of 5) [2/18/2003 5:24:22 AM]

StockCharts.com - Commodity Channel Index (CCI)

(Click here to see a live example of CCI) For scaling purposes, Lambert set the constant at .015 to ensure that approximately 70 to 80 percent of CCI values would fall between -100 and +100. The CCI fluctuates above and below zero. The percentage of CCI values that fall between +100 and -100 will depend on the number of periods used. A shorter CCI will be more volatile with a smaller percentage of values between +100 and -100. Conversely, the more periods http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_CCI-print.html (2 of 5) [2/18/2003 5:24:22 AM]

StockCharts.com - Commodity Channel Index (CCI)

used to calculate the CCI, the higher the percentage of values between +100 and -100. Lambert's trading guidelines for the CCI focused on movements above +100 and below 100 to generate buy and sell signals. Because about 70 to 80 percent of the CCI values are between +100 and -100, a buy or sell signal will be in force only 20 to 30 percent of the time. When the CCI moves above +100, a security is considered to be entering into a strong uptrend and a buy signal is given. The position should be closed when the CCI moves back below +100. When the CCI moves below -100, the security is considered to be in a strong downtrend and a sell signal is given. The position should be closed when the CCI moves back above -100. Since Lambert's original guidelines, traders have also found the CCI valuable for identifying reversals. The CCI is a versatile indicator capable of producing a wide array of buy and sell signals. ●

●

●

CCI can be used to identify overbought and oversold levels. A security would be deemed oversold when the CCI dips below -100 and overbought when it exceeds +100. From oversold levels, a buy signal might be given when the CCI moves back above -100. From overbought levels, a sell signal might be given when the CCI moved back below +100. As with most oscillators, divergences can also be applied to increase the robustness of signals. A positive divergence below -100 would increase the robustness of a signal based on a move back above -100. A negative divergence above +100 would increase the robustness of a signal based on a move back below +100. Trendline breaks can be used to generate signals. Trendlines can be drawn connecting the peaks and troughs. From oversold levels, an advance above -100 and trendline breakout could be considered bullish. From overbought levels, a decline below +100 and a trendline break could be considered bearish.

Traders and investors use the CCI to help identify price reversals, price extremes and trend strength. As with most indicators, the CCI should be used in conjunction with other aspects of technical analysis. CCI fits into the momentum category of oscillators. In addition to momentum, volume indicators and the price chart may also influence a technical assessment. Brooktrout

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_CCI-print.html (3 of 5) [2/18/2003 5:24:22 AM]

StockCharts.com - Commodity Channel Index (CCI)

The 25-day CCI for Brooktrout (BRKT) provides an example using Lambert's guidelines. Even though a few signals are good, using crosses above and below +100/-100 resulted in plenty of whipsaws. In January, the stock broke resistance at 20 and proceeded to double in the next few weeks. The CCI moved above and below +100 several times, but the stock remained in a strong uptrend. The CCI did manage to remain above +50 for about 7 weeks (blue oval), but the whipsaws below +100 could have caused an early exit. Whipsaws do not make an indicator bad. However, traders and investors should learn to use the CCI in conjunction with other indicators and chart analysis. In addition, various time frames for the CCI should be tested as well as buy and sell points. For Brooktrout, a buy point on a cross above and below +50 may have worked better. What works for one stock may not necessarily work for another stock. SharpChart Application http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_CCI-print.html (4 of 5) [2/18/2003 5:24:22 AM]

StockCharts.com - Commodity Channel Index (CCI)

Using SharpCharts, the CCI can be set as an indicator above or below a security's price plot. The first box to the right sets the number of periods to calculate the indicator. The default setting is 20 periods and the indicator can be used on daily, weekly or monthly charts. Horizontal lines have been set at -100, 0 and +100 to help identify extremes and centerline crossovers. When the indicator moves above +100 or below -100, the portion above or below will be shaded. A number of CCI windows can be opened on any chart and users are invited to compare different settings.

Written by Arthur Hill

Send us your Feedback!

©2002 StockCharts.com All Rights Reserved Terms of Use

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_CCI-print.html (5 of 5) [2/18/2003 5:24:22 AM]

StockCharts.com - Chaikin Money Flow Part 1

Chaikin Money Flow Part 1

Introduction

Developed by Marc Chaikin, the Chaikin Money Flow oscillator is calculated from the daily readings of the Accumulation/Distribution Line. The basic premise behind the Accumulation Distribution Line is that the degree of buying or selling pressure can be determined by the location of the close relative to the high and low for the corresponding period (Closing Location Value). There is buying pressure when a stock closes in the upper half of a period's range and there is selling pressure when a stock closes in the lower half of the period's trading range. The Closing Location Value multiplied by volume forms the Accumulation/Distribution Value for each period. (See our Chart School article for a detailed analysis of the Accumulation/Distribution Line.) Ciena

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_ChaikinMoneyFlow1-print.html (1 of 6) [2/18/2003 5:24:35 AM]

StockCharts.com - Chaikin Money Flow Part 1

(Click here to see a live example of CMF)

Methodology

The CIEN chart details the breakdown of the daily Accumulation/Distribution Values and how they relate to Chaikin Money Flow. The formula for Chaikin Money Flow is the cumulative total of the Accumulation/Distribution Values for 21 periods divided by the cumulative total of volume for 21 periods. On the CIEN chart, the purple box encloses 21 days of Accumulation/Distribution Values. The total of these 21 days divided by the total for the 21 days of volume forms http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_ChaikinMoneyFlow1-print.html (2 of 6) [2/18/2003 5:24:35 AM]

StockCharts.com - Chaikin Money Flow Part 1

the value of Chaikin Money Flow at the end of that day (purple arrow). To calculate the next day, the Accumulation/Distribution Value from the first day is removed and the value for the next day is entered into the equation. The number of periods can be changed to best suit a particular security and timeframe. The 21-day Chaikin Money Flow is a good representation of the buying and selling pressure for the past month. A month is long enough to filter out the random noise. By using a longer timeframe, the indicator will be less volatile and be less prone to whipsaws. For weekly and monthly charts, a shorter timeframe is usually suitable. Generally speaking, Chaikin Money Flow is considered bullish when it is positive and bearish when it is negative. The next item to assess is the length of time Chaikin Money Flow has remained positive or negative. Even though divergences are not an intricate part of the strategy behind Chaikin Money Flow, the absolute level and general direction of the oscillator can be important. Accumulation Indications

The Chaikin Money Flow oscillator generates bullish signals by indicating that a security is under accumulation. There are three items that determine if a security is under accumulation and the strength of the accumulation. 1. The first and most obvious signal to look for: is Chaikin Money Flow greater than zero? It is an indication of buying pressure and accumulation when the indicator is positive 2. The second item: determine how long the oscillator has been able to remain above zero. The longer the oscillator remains above zero, the more evidence there is that the security is under sustained accumulation. Extended periods of accumulation or buying pressure are bullish and indicate that sentiment towards the security remains positive. 3. The third indication: the actual level of the oscillator. Not only should the oscillator remain above zero, but it should also be able to increase and attain a certain level. The more positive the reading is, the more evidence of buying pressure and accumulation. There is such a thing as weak buying! This is usually a judgment call, based on prior levels for the oscillator. Alcoa

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_ChaikinMoneyFlow1-print.html (3 of 6) [2/18/2003 5:24:35 AM]

StockCharts.com - Chaikin Money Flow Part 1

On the chart for AA, Chaikin Money Flow actually strengthened while the stock continued to decline. For most of October, the stock traded flat while Chaikin Money Flow remained positive and continued to strengthen. The accumulation levels, as evidenced by Chaikin Money Flow, were very strong in October. The stock fell at the end of October and Chaikin Money Flow declined in November. When the stock fell, distribution levels never surpassed -.10, indicating that selling pressure was not that intense. In late November, the stock managed a comeback and broke resistance at 64. Chaikin Money Flow formed a higher low and returned to positive territory to confirm the breakout. Selling pressure dried up quickly and Chaikin Money Flow was able to bounce back in strong fashion. The evidence is clearly bullish, but to capitalize a trader would have had to act fast. AOL

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_ChaikinMoneyFlow1-print.html (4 of 6) [2/18/2003 5:24:35 AM]

StockCharts.com - Chaikin Money Flow Part 1

The chart for AOL is a bit different. The stock formed a double bottom in August and September while Chaikin Money Flow formed a rather large positive divergence. This divergence was not a signal, but would have served as an alert that the selling pressure was decreasing. Divergences can be difficult to act on and should be used in conjunction with other aspects of technical analysis. By the time the stock broke resistance at 52, Chaikin Money Flow has moved from a mildly bearish levels just above -.10 to moderately bullish levels just above +.13. The interesting point about AOL is the period from 28-Sept to 22-Oct (gray lines). During this period, the stock traded sideways, but Chaikin Money Flow continued to strengthen as buying pressure intensified. The oscillator moved from +.1208 on 28-Sept to +.2377 on 22-Oct. Buying pressure has nearly doubled. This was a clearly bullish indication and the stock soon obliged with an advance from the low fifties to over 90. In Part 2, we examine how Chaikin Money Flow measures distribution or selling pressure and offer some strategies for using the oscillator with other indicators.

Written by Arthur Hill

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_ChaikinMoneyFlow1-print.html (5 of 6) [2/18/2003 5:24:35 AM]

StockCharts.com - Chaikin Money Flow Part 1

Part 1 | Part 2

Send us your Feedback!

©2002 StockCharts.com All Rights Reserved Terms of Use

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_ChaikinMoneyFlow1-print.html (6 of 6) [2/18/2003 5:24:35 AM]

StockCharts.com - Chaikin Money Flow Part 2

Chaikin Money Flow Part 2

Distribution Indications

The Chaikin Money Flow oscillator generates bearish signals by indicating that a security is experiencing selling pressure, or is perhaps under distribution. As with the bullish signals, there are three items used to determine whether or not a security is experiencing selling pressure and the degree of selling pressure. 1. The first and most obvious bearish signal is when Chaikin Money Flow is less than zero. A negative reading indicates that the security in question is under selling pressure or experiencing distribution. 2. The second potentially bearish signal is the length of time that Chaikin Money Flow has remained negative. The longer the oscillator remains negative, the greater the evidence of sustained selling pressure or distribution. Extended periods below zero indicate that sentiment towards the underlying security is bearish and there is likely to be downward pressure on the price as well. The length of time can be determined by measuring the percentage of time that the indicator remains below zero. If Chaikin Money Flow is negative to 3 out of 4 weeks, then it would be experiencing selling pressure 75% of the time. 3. The third potentially bearish signal is the degree of selling pressure or distribution. This can be determined by the oscillator's absolute level. Readings on either side of the zero line or within 10 percent of both sides (plus or minus .10) are usually not considered strong enough to warrant a bullish or bearish signal. Once the indicator moves below -.10, the degree selling pressure begins to warrant a bearish signal. (A move above .10 would be significant enough to warrant a bullish signal). Any further movement would increase the degree of selling pressure and the bearish or bullish inclination. Marc Chaikin considers a reading below -25 percent (-.25) to be indicative of strong selling pressure. Conversely, a reading above .25 is considered to be indicative of strong buying pressure. These levels are general guidelines and establishing important levels will depend on the characteristics of the individual security and past readings for Chaikin Money Flow. J C Penny

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_ChaikinMoneyFlow2-print.html (1 of 8) [2/18/2003 5:24:45 AM]

StockCharts.com - Chaikin Money Flow Part 2

J. C. Penny (JCP) is an example of a stock that experienced distribution for many weeks before the price actually fell. Once the price began to fall, the indicator remained in negative territory for an extended period of time. From March to May, Chaikin Money Flow had been positive (green). On 18-May, the stock gapped up on the open, but the indicator abruptly fell and turned negative (red arrows). The stock advanced intraday on the 18th, but fell by the close to end the day near the lows. Based on the previous close, the stock advanced. However, from the perspective of Chaikin Money Flow, the stock closed near the low for the day on heavy volume, which is regarded as selling pressure. J C Penny

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_ChaikinMoneyFlow2-print.html (2 of 8) [2/18/2003 5:24:45 AM]

StockCharts.com - Chaikin Money Flow Part 2

To prove that this abrupt change was not a fluke, the indicator declined further over the next several weeks and remained negative for almost 3 months, indicating that selling pressure was strong in the stock. Not only did the selling pressure remain for an extended period, but also the degree of selling pressure increased. Chaikin Money Flow reached a low of -.468 (negative 46.8 percent) while the stock was near its highs around 50. The stock began to confirm the selling pressure and worked its way down in June and July. There were a few weeks in August when the indicator turned positive. This might have been seen as bullish, but it lasted a mere 3 weeks and Chaikin Money Flow only managed to get as high as +.1270. Furthermore, the price action of the stock never confirmed this strength and it is likely that other price and momentum indicators were bearish as well. The positive readings did not last long and by early September, Chaikin Money Flow was trading below -.25 and the stock was trading around 36. This was a solid signal that selling pressure in the stock remained heavy and there would likely be downward pressure on the price before long. The stock subsequently declined below 20 and Chaikin Money Flow has not been positive since late August. All three indications of selling pressure were prevalent in JCP: 1. Chaikin Money Flow turned negative before the stock declined. http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_ChaikinMoneyFlow2-print.html (3 of 8) [2/18/2003 5:24:45 AM]

StockCharts.com - Chaikin Money Flow Part 2

2. The indicator remained negative for 6 out of 7 months (85% of the time). 3. Almost all of the negative readings were below -.10 and many times the indicator dipped below -.25. IBM

IBM provides an excellent example of a reaction rally that had failure written all over it. When the stock peaked in July, Chaikin Money Flow was already well off of its highs. The indicator was still positive and mildly bullish, but could not surpass +.10 to even partially confirm the high. The indicator formed a double top in July with both peaks well below +.10. After the decline in late July, the stock began to find support and rallied in August, but Chaikin Money Flow would have none of it. The indicator broke below -.10 twice and remained negative for almost the entire month. When the stock reached its http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_ChaikinMoneyFlow2-print.html (4 of 8) [2/18/2003 5:24:45 AM]

StockCharts.com - Chaikin Money Flow Part 2

September reaction high, Chaikin Money Flow was still negative. After the September high in the stock, things began to fall apart. On 17-Sept, the stock declined with heavy volume and Chaikin Money Flow recorded a new reaction low. Each of these items is marked with a blue arrow on the chart. By this time, selling pressure had been evident for over a month. Chaikin Money Flow had been negative the whole time and had progressively weakened. The sharp decline in the stock on the heaviest volume in over 4 months indicated something was not right. The final straw came when support at 118.5 was broken and Chaikin Money Flow was trading below -.20. Chaikin Money Flow and other Indicators

It is best to choose indicators that complement each other. In a recent interview with Technical Analysis of Stocks and Commodities magazine, Marc Chaikin advises against using indicators that have common characteristics. It would be redundant to analyze both Momentum and MACD. These are both momentum oscillators that are based on the closing price and reflect the rate of change. Their signals will not be exactly the same, but it would be a waste of valuable time to analyze both. Chaikin singles out the Stochastic Oscillator, CCI and RSI as similar indicators. All three are banded momentum oscillators that are good for detecting overbought and oversold conditions. Buy and sell signals are also generated in much the same fashion. All three are excellent indicators, but it would be a waste of time to follow all three when one will be sufficient. Chaikin Money Flow can be used to identify the tradable trend. If Chaikin Money Flow has been above zero for most of the past three months, then prudence would dictate that the tradable trend is up. The oscillator is indicating that buying pressure prevails. It would not be sensible to attempt a short sale if the tradable trend is up. By identifying the tradable trend, traders can ignore bearish signals and only pay attention to signals that concur. If Chaikin Money Flow indicates that buying pressure prevails, then positive divergences, bullish moving average crossovers, bullish centerline crossovers and bullish oversold crossovers would be potential buy signals. (A bullish oversold crossover occurs when an indicator advances above the oversold line. This would be a move from below 30 to above 30 for RSI). All bearish signals would be ignored, at least as long as Chaikin Money Flow indicated that buying pressure reigned. One possible combination of indicators would be the following: ●

●

●

●

Chaikin Money Flow - A non-trend-following volume indicator to identify buying and selling pressure. RSI - A momentum indicator used to identify potential overbought and oversold levels. Moving averages - A trend-following indicator to identify the underlying trend in the stock. Price relative - A comparative indicator to identify the strength of the stock

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_ChaikinMoneyFlow2-print.html (5 of 8) [2/18/2003 5:24:45 AM]

StockCharts.com - Chaikin Money Flow Part 2

relative to a major index. These four indicators have little in common and complement each other very well. Conclusion

Chaikin Money Flow is an indicator that is best used in conjunction with other aspects of technical analysis. This is usually the case with indicators, but probably even more so in this case. The oscillator is unlike a momentum oscillator and is not influenced by the price change from day to day. Instead, the indicator focuses on the location of the close relative to the range for the period (daily or weekly). This is the strength of Chaikin Money Flow, but can also be its weakness. Because Chaikin Money Flow does not reflect the change in price from day to day or week to week, large opening gaps are sometimes not reflected in the indicator. Sometimes the indicator moves in the opposite direction of the gap and creates a misleading picture. Starbucks

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_ChaikinMoneyFlow2-print.html (6 of 8) [2/18/2003 5:24:45 AM]

StockCharts.com - Chaikin Money Flow Part 2

Starbucks (SBUX) formed a large down gap on 1-July with extremely heavy volume. Even though the stock opened more than 10 points lower, it managed to close on the high for the day. Strong closes indicate accumulation and the heavy volume amplified this message to cause a large jump in the indicator. The strength was a bit misleading and the indicator slowly declined over the next 20 days. On the 21st day, the data from 1-July was removed and the current day's data added. This caused an immediate drop in the indicator. Chaikin Money Flow was well below zero the next day and more accurately reflected the selling pressure taking place in the stock. Even though Chaikin Money Flow can be used on an intraday, daily or weekly basis, it was designed with daily data in mind. One day is an unambiguous time period with measurable volume and a specific open, high, low and close. This definability may http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_ChaikinMoneyFlow2-print.html (7 of 8) [2/18/2003 5:24:45 AM]

StockCharts.com - Chaikin Money Flow Part 2

lessen in the future, with the proliferation of after-hours trading, but determining the location of the close relative to the high and low is still fairly straightforward. When dealing with weekly or monthly data, the beginning and end are less precise. This imprecision can affect the location of the close relative to the high and low for the period. Weekly is obviously more definable than monthly, but less definable than daily. This is something to consider when analyzing Chaikin Money Flow with periods other than daily. Chaikin advocated a 21-day time frame for Chaikin Money Flow. If Chaikin Money Flow is to be used on a weekly chart, a shorter time frame will probably work better. A 21day period represents about one month of trading and will allow for some smoothing. A shorter timeframe may prove too choppy, but a longer time frame may lag too much. Each security will have its own optimum time frame. Keep in mind that the short-term trend is not as important as the absolute level. As long as the indicator remains above zero, it is considered bullish. It is also important to gauge the length of time that the indicator remains positive. If the indicator is positive for 7 out of 9 weeks, then buying pressure is the order of the day. The two negative weeks are a blip on the radar, and should not be taken out of context. Part 1 | Part 2

Written by Arthur Hill

Send us your Feedback!

©2002 StockCharts.com All Rights Reserved Terms of Use

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_ChaikinMoneyFlow2-print.html (8 of 8) [2/18/2003 5:24:45 AM]

StockCharts.com - Chaikin Oscillator

Chaikin Oscillator

Introduction

The Accumulation/Distribution Line was covered in a previous article; here we will examine an indicator that stems from the concept behind the Accumulation/Distribution Line: the Chaikin Oscillator or Chaikin A/D Oscillator as it is sometimes called, named after its creator, Marc Chaikin. Before reading this article, you may want to become familiar with the concepts behind the Accumulation/Distribution Line. The basic premise of the Accumulation/Distribution Line is that the degree of buying or selling pressure can be determined by the location of the close, relative to the high and low for the corresponding period. There is buying pressure when a stock closes in the upper half of a period's range and there is selling pressure when a stock closes in the lower half of the period's trading range. Ciena

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_ChaikinOscillator-print.html (1 of 6) [2/18/2003 5:24:57 AM]

StockCharts.com - Chaikin Oscillator

The CIEN chart shows the relationship among each period's Accumulation/Distribution Value, Accumulation/Distribution Line, and Chaikin Oscillator. The same four points noted in the Accumulation/Distribution Line article have been noted in this example for reference as well. Methodology

The Chaikin Oscillator is simply the Moving Average Convergence Divergence indicator (MACD) applied to the Accumulation/Distribution Line. The formula is the difference between the 3-day exponential moving average and the 10-day exponential moving average of the Accumulation/Distribution Line. Just as the MACD-Histogram is an http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_ChaikinOscillator-print.html (2 of 6) [2/18/2003 5:24:57 AM]

StockCharts.com - Chaikin Oscillator

indicator to predict moving average crossovers in MACD, the Chaikin Oscillator is an indicator to predict changes in the Accumulation/Distribution Line. Many of the same signals that apply to MACD are also applicable to the Chaikin Oscillator. Keep in mind though, that these signals relate to the Accumulation/Distribution Line, not directly to the stock itself. Readers may want to refer to our MACD series for more detailed information on various signals such as positive divergences, negative divergences and centerline crossovers. Just as MACD injects momentum characteristics into moving averages, the Chaikin Oscillator gives momentum characteristics to the Accumulation/Distribution Line, which can be a bit of a laggard sometimes. By adding momentum features, the Chaikin Oscillator will lead the Accumulation/Distribution Line. The CIEN chart confirms that movements in the Accumulation/Distribution Line are usually preceded by corresponding divergences in the Chaikin Oscillator. 1. The July negative divergence in the Chaikin Oscillator foreshadowed the impending weakness in the Accumulation/Distribution Line. This was a slant type divergence that is characterized by its lack of distinctive peaks to form the divergence. The Chaikin Oscillator peaked about a week before the Accumulation/Distribution Line and formed a bearish centerline crossover 2 weeks later. When the oscillator is negative, it implies that momentum for the Accumulation/Distribution Line is negative or bearish, which would ultimately be a negative reflection on the stock. 2. The August positive divergence in the Chaikin Oscillator foreshadowed a sharp advance in the Accumulation/Distribution Line. This divergence was longer and could have been referred to as a trough divergence. In a trough divergence there are two noticeable troughs, one higher than the other, that form the divergence. The bullish, or positive, momentum was confirmed when the Chaikin Oscillator formed a bullish centerline crossover in late August. Bullish Signals

There are two bullish signals that can be generated from the Chaikin Oscillator: positive divergences and centerline crossovers. Because the Chaikin Oscillator is an indicator of an indicator, it is prudent to look for confirmation of a positive divergence, by a bullish moving average crossover for example, before counting this as a bullish signal. The chart for KO is an excellent example of a positive divergence that has been confirmed by a centerline crossover. Coca Cola Co.

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_ChaikinOscillator-print.html (3 of 6) [2/18/2003 5:24:57 AM]

StockCharts.com - Chaikin Oscillator

1. The positive divergence is sharp and pronounced. When using an indicator of an indicator, it is preferable to take only strong signals. Note the steepness of the positive divergence. 2. The bullish centerline crossover occurred in the Chaikin Oscillator before the Accumulation/Distribution Line broke to a new reaction high. 3. At the point of the centerline crossover (green dotted line), the stock also broke resistance and the bullish signal was further validated. Bearish Signals

In direct contrast to the bullish signals, there are two bearish signals that can be

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_ChaikinOscillator-print.html (4 of 6) [2/18/2003 5:24:57 AM]

StockCharts.com - Chaikin Oscillator

generated from the Chaikin Oscillator: a negative divergence and a bearish centerline crossover. Allow a negative divergence to be confirmed by a bearish centerline crossover, before a bearish signal is rendered. The chart for MRK shows a recent bearish signal that coincided with a support break in the stock. Coca Cola Co.

1. The negative divergence is not as sharp and pronounced at the positive divergence in KO, but it is detectable none the less. Divergences that cover long time spans are sometimes difficult to time for a trade. 2. It is easy to see the effects of price action on the Chaikin Oscillator and the Accumulation/Distribution Line in this example. The blue lines mark a period when the stock traded basically flat for 13 days. However, many of the closes for this period were below the midway point and some were near the intraday lows. Note the action of the Chaikin Oscillator and Accumulation/Distribution Line during this period; both declined markedly. 3. The bearish centerline crossover to confirm the divergence occurred just recently and coincided with a break of support in the stock and a trendline break in the Accumulation/Distribution Line. Conclusion

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_ChaikinOscillator-print.html (5 of 6) [2/18/2003 5:24:57 AM]

StockCharts.com - Chaikin Oscillator

The Chaikin Oscillator is good for adding momentum to the Accumulation/Distribution Line, but can sometimes add a little too much momentum and be difficult to interpret. The moving averages are both relatively short and will therefore be more sensitive to changes in the Accumulation/Distribution Line. Sensitivity is important, but one must also be able to interpret the indicator. Those with the software and resources may try changing the moving averages on the indicator(an option available in our SharpCharts 'Indicator Windows') to further smooth the fluctuations. This indicator should definitely be used in conjunction with other aspects of technical analysis. Chaikin Money Flow is one answer to the volatility that has been created from the Chaikin Oscillator.

Written by Arthur Hill

Send us your Feedback!

©2002 StockCharts.com All Rights Reserved Terms of Use

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_ChaikinOscillator-print.html (6 of 6) [2/18/2003 5:24:57 AM]

StockCharts.com - Moving Averages - Part 1

Moving Averages - Part 1

Introduction

Moving averages are one of the most popular and easy to use tools available to the technical analyst. By using an average of prices, moving averages smooth a data series and make it easier to spot trends. This can be especially helpful in volatile markets.

In the first part of this series on moving averages, we will examine the differences between the two most popular moving averages: the simple moving average and the exponential moving average. In part two, we will look at how moving averages can be used as tools of technical analysis. Simple Moving Average (SMA)

(Click here to see a live example of a Simple Moving Average) A simple moving average is formed by finding the average price of a security over a set http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_movingAvg-print.html (1 of 10) [2/18/2003 5:25:12 AM]

StockCharts.com - Moving Averages - Part 1

number of periods. Most often, the closing price is used to compute the moving average. For example: a 5-day moving average would be calculated by adding the closing prices for the last 5 days and dividing the total by 5.

A moving average moves because as the newest period is added, the oldest period is dropped. If the next closing price in the average is 15, then this new period would be added and the oldest day, which is 10, would be dropped. The new 5-day moving average would be calculated as follows:

Over the last 2 days, the moving average moved from 12 to 13. As new days are added, the old days will be subtracted and the moving average will continue to move over time.

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_movingAvg-print.html (2 of 10) [2/18/2003 5:25:12 AM]

StockCharts.com - Moving Averages - Part 1

In the example above, using closing prices from Eastman Kodak (EK), day 10 is the first day possible to calculate a 10-day moving average. As the calculation continues, the newest day is added and the oldest day is subtracted. The 10-day moving average for day 11 is calculated by adding the prices of day 2 through day 11 and dividing by 10. The averaging process then moves on to the next day where the 10-day moving average for day 12 is calculated by adding the prices of day 3 through day 12 and dividing by 10.

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_movingAvg-print.html (3 of 10) [2/18/2003 5:25:12 AM]

StockCharts.com - Moving Averages - Part 1

The chart above is a plot that contains the data sequence in the table. The moving average begins on day 10 and continues. This simple illustration highlights the fact that moving averages are lagging indicators and will always be behind the price. The price of EK is trending down, but the moving average, which is based on the previous 10 days of data, remains above the price. If the price were rising, the moving average most likely be below. Because moving averages are lagging indicators, they fit in the category of trend following. When prices are trending, moving averages work well. However, when prices are not trending, moving averages do not work. Exponential Moving Average (EMA)

(Click here to see a live example of an Exponential Moving Average) In order to reduce the lag in simple moving averages, technicians sometimes use exponential moving averages, or exponentially weighted moving averages. Exponential moving averages reduce the lag by applying more weight to recent prices relative to older prices. The weighting applied to the most recent price depends on the length of the moving average. The shorter the exponential moving average is, the more weight that will be applied to the most recent price. For example: a 10-period exponential moving average weighs the most recent price 18.18% and a 20-period exponential moving average weighs the most recent price 9.52%. The method for calculating the exponential moving average is fairly complicated. The important thing to remember is http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_movingAvg-print.html (4 of 10) [2/18/2003 5:25:12 AM]

StockCharts.com - Moving Averages - Part 1

that the exponential moving average puts more weight on recent prices. As such, it will react quicker to recent price changes than a simple moving average. For those who wish to see an example formula for an exponential moving average, one is provided below. Others may prefer to skip this section and move on the comparison of the moving averages. Exponential Moving Average Calculation The formula for an exponential moving average is: X = (K x (C - P)) + P X = Current EMA C = Current Price P = Previous period's EMA* K = Smoothing constant (*A SMA is used for first period's calculation) The smoothing constant applies the appropriate weighting to the most recent price relative to the previous exponential moving average. The formula for the smoothing constant is: K = 2/(1+N) N = Number of periods for EMA For a 10-period EMA, the smoothing constant would be .1818.

The EMA formula works by weighting the difference between the current period's price and the previous period's EMA and adding the result to the previous period's EMA. There are two possible outcomes: the weighted difference is either positive or negative. 1. If the current price (C) is higher than the previous period's EMA (P), the difference will be positive (C - P). The positive difference is weighted by multiplying it by the constant ((C - P) x K) and the answer is added to the previous period's EMA, resulting in a new EMA that is higher ((C - P) x K) + P. 2. If the current price is lower than the previous period's EMA, the difference will be http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_movingAvg-print.html (5 of 10) [2/18/2003 5:25:12 AM]

StockCharts.com - Moving Averages - Part 1

negative (C - P). The negative difference is weighted by multiplying it by the constant ((C - P) x K) and the final result is added to the previous period's EMA, resulting in a new EMA that is lower ((C - P) x K) + P. Below is a table with the results of an exponential moving average calculation for Eastman Kodak. For the first period's exponential moving average, the simple moving average was used as the previous period's exponential moving average (yellow highlight for the 10th period). From period 11 onwards, the previous period's EMA was used. The calculation in period 11 breaks down as follows: 1. (C - P) = (61.33 - 63.682) = -2.352 2. (C - P) x K = -2.352 x .181818 = -0.4276 3. ((C - P) x K) + P = -0.4276 + 63.682 = 63.254

*The 10-period simple moving average is used for the first calculation only. After that the previous period's EMA is used. http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_movingAvg-print.html (6 of 10) [2/18/2003 5:25:12 AM]

StockCharts.com - Moving Averages - Part 1

(Click here to download this table as an Excel spreadsheet.)

Simple Versus Exponential

From afar, it would appear that the difference between an exponential moving average and a simple moving average is minimal. For this example, which uses only 20 trading days, the difference is minimal, but a difference nonetheless. The exponential moving average is consistently closer to the actual price. On average, the EMA is 3/8 of a point closer to the actual price than the SMA.

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_movingAvg-print.html (7 of 10) [2/18/2003 5:25:12 AM]

StockCharts.com - Moving Averages - Part 1

From day 10 to day 20, the EMA was closer to the price than the SMA 9 out of 10 times. The only time the SMA was closer was in period number 18 (yellow highlight), and this did not last long. The average absolute difference between the exponential moving average and the current price was 1 and the simple moving average had an average absolute difference of 1.33. This means that on average, the exponential moving http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_movingAvg-print.html (8 of 10) [2/18/2003 5:25:12 AM]

StockCharts.com - Moving Averages - Part 1

average was 1 point above or below the current price and the simple moving average was 1.33 points above or below the current price. When EK stopped falling and started to trade flat, the SMA kept on declining. During this period, the SMA was closer to the actual price than the EMA. The EMA began to level out with the actual price and remain further away. This was because the actual price started to level out. Because of its lag, the SMA continued to decline and even touched the actual price on 13-Dec.

A comparison of a 50-day EMA and a 50-day SMA for Compaq also shows that the EMA picks up on the trend quicker than the SMA. The blue arrows mark points when the stock started a strong trend. By giving more weight to recent prices, the EMA reacted quicker than the SMA and remained closer to the actual price. The gray circle shows when the trend began to slow and a trading range developed. When the change from trend to trading began, the SMA was closer to the price. As the trading range continued into the latter part of 1999, both moving averages converged. In later 1999, CPQ started to trend up and the EMA was quicker to pick up on the recent price change and remain closer to the price. Which is better?

Which moving average you use will depend on your trading and investing style and preferences. The simple moving average obviously has a lag, but the exponential moving average may be prone to quicker breaks. Some traders prefer to use http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_movingAvg-print.html (9 of 10) [2/18/2003 5:25:12 AM]

StockCharts.com - Moving Averages - Part 1

exponential moving averages for shorter time periods to capture changes quicker. Some investors prefer simple moving averages over long time periods to identify long-term trend changes. In addition, much will depend on the individual security in question. A 50day SMA might work great for identifying support levels in the Nasdaq, but a 100-day EMA may work better for the Dow Transports. Moving average type and length of time will depend greatly on the individual security and how it has reacted in the past. The initial thought for some is that greater sensitivity and quicker signals are bound to be beneficial. This is not always true and brings up a great dilemma for the technical analyst: the trade off between sensitivity and reliability. The more sensitive an indicator is, the more signals that will be given. These signals may prove timely, but with increased sensitivity comes an increase in false signals. The less sensitive an indicator is, the fewer signals that will be given. However, less sensitivity leads to fewer and more reliable signals. Sometimes these signals can be late as well. For moving averages, the same dilemma applies. Shorter moving averages will be more sensitive and generate more signals. The EMA, which is generally more sensitive than the SMA, will also be likely to generate more signals. However, there will also be an increase in the number of false signals and whipsaws. Longer moving averages will move slower and generate fewer signals. These signals will likely prove more reliable, but they also may come late. Each investor or trader should experiment with different moving average lengths and types to examine the trade-off between sensitivity and signal reliability. In Part 2, we examine how to use moving averages to identify support and resistance levels, recognize trends and develop a trading system.

Written by Arthur Hill Part 1 | Part 2

Send us your Feedback!

©2002 StockCharts.com All Rights Reserved Terms of Use

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_movingAvg-print.html (10 of 10) [2/18/2003 5:25:12 AM]

StockCharts.com - Moving Averages - Part 2

Moving Averages - Part 2

Moving Averages

Trend-Following Indicator Moving averages smooth out a data series and make it easier to identify the direction of the trend. Because past price data is used to form moving averages, they are considered lagging, or trend following, indicators. Moving averages will not predict a change in trend, but rather follow behind the current trend. Therefore, they are best suited for trend identification and trend following purposes, not for prediction. When to Use Because moving averages follow the trend, they work best when a security is trending and are ineffective when a security moves in a trading range. With this in mind, investors and traders should first identify securities that display some trending characteristics before attempting to analyze with moving averages. This process does not have to be a scientific examination. Usually, a simple visual assessment of the price chart can determine if a security exhibits characteristics of trend. In its simplest form, a security's price can be doing only one of three things: trending up, trending down or trading in a range. An uptrend is established when a security forms a series of higher highs and higher lows. A downtrend is established when a security forms a series of lower lows and lower highs. A trading range is established if a security cannot establish an uptrend or downtrend. If a security is in a trading range, an uptrend is started when the upper boundary of the range is broken and a downtrend begins when the lower boundary is broken. Ford

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_movingAvg2-print.html (1 of 11) [2/18/2003 5:25:41 AM]

StockCharts.com - Moving Averages - Part 2

In the Ford example, it is evident that a stock can go through both trending and trading phases. The red circles indicate trading range phases that are interspersed among trending periods. It is sometimes difficult to determine when a trend will stop and a trading range will begin or when a trading range will stop and a trend will begin. The basic rules for trends and trading ranges laid out above can be applied to Ford. Notice the trading range periods, the breakouts (both up and down) and the trending periods. The moving average worked well in times of trend, but faired poorly in times of trading. Also note how the moving average lags behind the trend: it is always under the price during an uptrend and above the price during a downtrend. A 50-day simple moving average was used for this example. However, the number of periods is optional and much will depend on the characteristics of the security as well as an individual's trading and investing style.

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_movingAvg2-print.html (2 of 11) [2/18/2003 5:25:41 AM]

StockCharts.com - Moving Averages - Part 2

3M

If price movements are choppy and erratic over an extended period of time, then a moving average is probably not the best choice for analysis. The chart for MMM shows a security that moved from 70 to 90 in a few weeks in late April. Prior to this advance, the price gyrated above and below its moving average. After the advance, the stock continued its erratic behavior without developing much of a trend. Trying to analyze this security based on a moving average is likely to be a lesson in futility. AOL

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_movingAvg2-print.html (3 of 11) [2/18/2003 5:25:41 AM]

StockCharts.com - Moving Averages - Part 2

A quick look at the chart for AOL shows a different picture than for MMM. Over the same time period, AOL has shown the ability to trend. There are 3 distinct trends or price movements that extend for a number of months. Once the stock moves above or below the 70-day SMA, it usually continues in that direction for a little while longer. MMM, on the other hand, broke above and below its 70-day SMA numerous times and would have been prone to numerous whipsaws. A longer moving average would probably work better for MMM, but it is clear that there are fewer characteristics of trend than in AOL. Moving Average Settings Once a security has been deemed to have enough characteristics of trend, the next task will be to select the number of moving average periods and type of moving average. The number of periods used in a moving average will vary according to the security's volatility, trendiness and personal preferences. The more volatility there is, the more smoothing that will be required and hence the longer the moving average. Stocks that do not exhibit strong characteristics of trend may also require longer moving averages. There is no one set length, but some of the more popular lengths include 21, 50, 89, 150 and 200 days as well as 10, 30 and 40 weeks. Short-term traders may look for evidence of 2-3 week trends with a 21-day moving average, while longer-term investors may look for evidence of 3-4 month trends with a 40-week moving average. Trial and error is usually the best means for finding the best length. Examine how the moving average fits with the price data. If there are too many breaks, lengthen the moving average to decrease its sensitivity. If the moving average is slow to react, shorten the moving average to increase its sensitivity. In addition, you may want to try using both simple and exponential moving averages. Exponential moving averages are usually best for short-term situations that require a responsive moving average. Simple moving averages work well for longer-term situations that do not require a lot of sensitivity. http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_movingAvg2-print.html (4 of 11) [2/18/2003 5:25:41 AM]

StockCharts.com - Moving Averages - Part 2

Uses for Moving Averages

There are many uses for moving averages, but three basic uses stand out: ● ● ●

Trend identification/confirmation Support and Resistance level identification/confirmation Trading Systems

Trend Identification/Confirmation There are three ways to identify the direction of the trend with moving averages: direction, location and crossovers. The first trend identification technique uses the direction of the moving average to determine the trend. If the moving average is rising, the trend is considered up. If the moving average is declining, the trend is considered down. The direction of a moving average can be determined simply by looking at a plot of the moving average or by applying an indicator to the moving average. In either case, we would not want to act on every subtle change, but rather look at general directional movement and changes. Disney

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_movingAvg2-print.html (5 of 11) [2/18/2003 5:25:41 AM]

StockCharts.com - Moving Averages - Part 2

In the case of Disney, a 100-day exponential moving average (EMA) has been used to determine the trend. We do not want to act on every little change in the moving average, but rather significant upturns and downturns. This is not a scientific study, but a number of significant turning points can be spotted just based on visual observation (red circles). A few good signals were rendered, but also a few whipsaws and late signals. Much of the performance would depend on your entry and exit points. The length of the moving average influences the number of signals and their timeliness. Moving averages are lagging indicators. Therefore, the longer the moving average is, the further behind the price movement it will be. For quicker signals, a 50-day EMA could have been used. The second technique for trend identification is price location. The location of the price relative to the moving average can be used to determine the basic trend. If the price is http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_movingAvg2-print.html (6 of 11) [2/18/2003 5:25:41 AM]

StockCharts.com - Moving Averages - Part 2

above the moving average, the trend is considered up. If the price is below the moving average, the trend is considered down. Enron

This example is pretty straightforward. The long-term for ENE is determined by the location of the stock relative to its 100-day SMA. When ENE is above its 100-day SMA, the trend is considered bullish. When the stock is below the 100-day SMA, the trend is considered bearish. Buy and sell signals are generated by crosses above and below the moving average. There was a brief sell signal generated in Aug-98 and a false buy signal in Nov-99. Both of these signals occurred when Enron's trend began to weaken. For the most part though, this simple method would have kept an investor in throughout most of the bull move. The third technique for trend identification is based on the location of the shorter moving average relative to the longer moving average. If the shorter moving average is above the longer moving average, the trend is considered up. If the shorter moving average is below the longer moving average, the trend is considered down. Xircom

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_movingAvg2-print.html (7 of 11) [2/18/2003 5:25:41 AM]

StockCharts.com - Moving Averages - Part 2

For Xircom, a 30/100 moving average crossover was used to determine the trend. When the 30-day moving average moves above the 100-day moving average, the trend is considered bullish. When the 30-day moving average declines below the 100-day moving average, the trend is considered bearish. A plot of the 30/100 differential is plotted below the price chart by using the Percentage Price Oscillator (PPO) set to (30,100,1). When the differential is positive the trend is considered up -- when it is negative the trend is considered down. As with all trend-following systems, the signals work well when the stock develops a strong trend, but are ineffective when the stock is in a trading range. Also notice that the signals tend to be late and after the move has begun. Again, trend following indicators are best for identification and following, not predicting. Support and Resistance Levels http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_movingAvg2-print.html (8 of 11) [2/18/2003 5:25:41 AM]

StockCharts.com - Moving Averages - Part 2

Another use of moving averages is to identify support and resistance levels. This is usually accomplished with one moving average and is based on historical precedent. As with trend identification, support and resistance level identification through moving averages works best in trending markets. Sun Microsystems

After breaking out of a trading range, Sun Microsystems successfully tested moving average support in late July and early August. Also notice that the June resistance breakout near 18 turned into support. Therefore, the moving average acted as a confirmation of resistance-turned-support. After this first test, the 50-day moving average went on to 4 more successful support tests over the next several months. A break of support from the 50-day moving average would serve as a warning that the stock may move into a trading range or may be about to change the direction of the trend. Such a break occurred in Apr-00 and the 50-day SMA turned into resistance later that month. When the stock broke above the 50-day SMA in early Jun-00, it returned to a support level until the Oct-00 break. In Oct-00, the 50-day SMA became a resistance level and that held for many months. SharpCharts and Moving Averages

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_movingAvg2-print.html (9 of 11) [2/18/2003 5:25:41 AM]

StockCharts.com - Moving Averages - Part 2

Moving averages are available as a price overlay feature on SharpCharts. From the price overlay option, you can choose either a simple moving average or an exponential moving average. The first box to the right is used to set the number of time periods. If charting on daily periods, then 50 would be for a 50-day moving average. If charting on weekly periods, then 50 would be for a 50-week moving average. The moving averages are based on closing prices and multiple moving averages can be overlaid the price plot. Conclusions

Moving averages can be effective tools to identify and confirm trend, identify support and resistance levels, and develop trading systems. However, traders and investors should learn to identify securities that are suitable for analysis with moving averages and how this analysis should be applied. Usually, an assessment can be made with a visual examination of the price chart, but sometimes it will require a more detailed approach. The ADX, Average Directional Index, is one tool that can help identify securities that are trending and those that are not. The advantages of using moving averages need to be weighed against the disadvantages. Moving averages are trend following, or lagging, indicators that will always be a step behind. This is not necessarily a bad thing though. After all, the trend is your friend and it is best to trade in the direction of the trend. Moving averages will help ensure that a trader is in line with the current trend. However, markets, stocks and securities spend a great deal of time in trading ranges, which render moving averages ineffective. Once in a trend, moving averages will keep you in, but also give late signals. Don't expect to get out at the top and in at the bottom using moving averages. As with most tools of technical analysis, moving averages should not be used on their own, but in conjunction with other tools that complement them. Using moving averages to confirm other indicators and analysis can greatly enhance technical analysis.

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_movingAvg2-print.html (10 of 11) [2/18/2003 5:25:41 AM]

StockCharts.com - Moving Averages - Part 2

Written by Arthur Hill Part 1 | Part 2

Send us your Feedback!

©2002 StockCharts.com All Rights Reserved Terms of Use

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_movingAvg2-print.html (11 of 11) [2/18/2003 5:25:41 AM]

StockCharts.com - MACD Part 1

MACD Part 1

The Combination Oscillator

Developed by Gerald Appel, Moving Average Convergence Divergence (MACD) is one of the simplest and most reliable indicators available. MACD uses moving averages, which are lagging indicators, to include some trend-following characteristics. These lagging indicators are turned into a momentum oscillator by subtracting the longer moving average from the shorter moving average. The resulting plot forms a line that oscillates above and below zero, without any upper or lower limits. MACD is a centered oscillator and the guidelines for using centered oscillators apply. MACD Formula

The most popular formula for the "standard" MACD is the difference between a security's 26-day and 12-day exponential moving averages. This is the formula that is used in many popular technical analysis programs, including SharpCharts, and quoted in most technical analysis books on the subject. Appel and others have since tinkered with these original settings to come up with a MACD that is better suited for faster or slower securities. Using shorter moving averages will produce a quicker, more responsive indicator, while using longer moving averages will produce a slower indicator, less prone to whipsaws. For our purposes in this article, the traditional 12/26 MACD will be used for explanations. Later in the indicator series, we will address the use of different moving averages in calculating MACD. Of the two moving averages that make up MACD, the 12-day EMA is the faster and the 26-day EMA is the slower. Closing prices are used to form the moving averages. Usually, a 9-day EMA of MACD is plotted along side to act as a trigger line. A bullish crossover occurs when MACD moves above its 9-day EMA and a bearish crossover occurs when MACD moves below its 9-day EMA. The Merrill Lynch chart below shows the 12-day EMA (thin green line) with the 26-day EMA (thin blue line) overlaid the price plot. MACD appears in the box below as the thick black line and its 9-day EMA is the thin blue line. The histogram represents the difference between MACD and its 9-day EMA. The histogram is positive when MACD is above its 9-day EMA and negative when MACD is below its 9-day EMA. Merrill Lynch

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_MACD1-print.html (1 of 8) [2/18/2003 5:25:56 AM]

StockCharts.com - MACD Part 1

What does MACD do?

MACD measures the difference between two moving averages. A positive MACD indicates that the 12-day EMA is trading above the 26-day EMA. A negative MACD indicates that the 12-day EMA is trading below the 26-day EMA. If MACD is positive and rising, then the gap between the 12-day EMA and the 26-day EMA is widening. This indicates that the rate-of-change of the faster moving average is higher than the rate-ofchange for the slower moving average. Positive momentum is increasing and this would be considered bullish. If MACD is negative and declining further, then the negative gap between the faster moving average (green) and the slower moving average (blue) is expanding. Downward momentum is accelerating and this would be considered bearish. MACD centerline crossovers occur when the faster moving average crosses the slower moving average. http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_MACD1-print.html (2 of 8) [2/18/2003 5:25:56 AM]

StockCharts.com - MACD Part 1

Merrill Lynch

(Click here to see a live example of MACD)

This Merrill Lynch chart shows MACD as a solid black line and its 9-day EMA as the thin blue line. Even though moving averages are lagging indicators, notice that MACD moves faster than the moving averages. In this example with Merrill Lynch, MACD also provided a few good trading signals as well. 1. In March and April, MACD turned down ahead of both moving averages and formed a negative divergence ahead of the price peak. 2. In May and June, MACD began to strengthen and make higher lows while both http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_MACD1-print.html (3 of 8) [2/18/2003 5:25:56 AM]

StockCharts.com - MACD Part 1

moving averages continued to make lower lows. 3. And finally, MACD formed a positive divergence in October while both moving averages recorded new lows. MACD Bullish Signals

MACD generates bullish signals from three main sources: 1. Positive divergence 2. Bullish moving average crossover 3. Bullish centerline crossover Positive Divergence Novellus

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_MACD1-print.html (4 of 8) [2/18/2003 5:25:56 AM]

StockCharts.com - MACD Part 1

A positive divergence occurs when MACD begins to advance and the security is still in a downtrend and makes a lower reaction low. MACD can either form as a series of higher lows or a second low that is higher than the previous low. Positive divergences are probably the least common of the three signals, but are usually the most reliable and lead to the biggest moves. Bullish Moving Average Crossover Novellus

A bullish moving average crossover occurs when MACD moves above its 9-day EMA or trigger line. Bullish moving average crossovers are probably the most common signals and as such are the least reliable. If not used in conjunction with other technical

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_MACD1-print.html (5 of 8) [2/18/2003 5:25:56 AM]

StockCharts.com - MACD Part 1

analysis tools, these crossovers can lead to whipsaws and many false signals. Moving average crossovers are sometimes used to confirm a positive divergence. The second low or higher low of a positive divergence can be considered valid when it is followed by a bullish moving average crossover. Sometimes it is prudent to apply a price filter to the moving average crossover in order to ensure that it will hold. An example of a price filter would be to buy if MACD breaks above the 9-day EMA and remains above for three days. The buy signal would then commence at the end of the third day. Bullish Centerline Crossover Apple

A bullish centerline crossover occurs when MACD moves above the zero line and into http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_MACD1-print.html (6 of 8) [2/18/2003 5:25:56 AM]

StockCharts.com - MACD Part 1

positive territory. This is a clear indication that momentum has changed from negative to positive, or from bearish to bullish. After a positive divergence and bullish moving average crossover, the centerline crossover can act as a confirmation signal. Of the three signals, moving average crossover are probably the second most common signals. Using a Combination of Signals Halliburton

Even though some traders may use only one of the above signals to form a buy or a sell signal, using a combination can generate more robust signals. In the Halliburton example, all three bullish signals were present and the stock still advanced another 20%. The stock formed a lower low at the end of February, but MACD formed a higher low, thus creating a potential positive divergence. MACD then formed a bullish crossover by moving above its 9-day EMA. And finally, MACD traded above zero to form a bullish http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_MACD1-print.html (7 of 8) [2/18/2003 5:25:56 AM]

StockCharts.com - MACD Part 1

centerline crossover. At the time of the bullish centerline crossover, the stock was trading at 32 1/4 and went above 40 immediately after that. In August, the stock traded above 50. In Part 2, we look at MACD bearish signals.

Written by Arthur Hill Part 1 | Part 2 | Part 3 | Part 4

Send us your Feedback!

©2002 StockCharts.com All Rights Reserved Terms of Use

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_MACD1-print.html (8 of 8) [2/18/2003 5:25:56 AM]

StockCharts.com - MACD Part 2

MACD Part 2

Bearish Signals

MACD generates bearish signals from three main sources. These signals are mirror reflections of the bullish signals. 1. Negative divergence 2. Bearish moving average crossover 3. Bearish centerline crossover Negative Divergence A negative divergence forms when the security advances or moves sideways and MACD declines. The negative divergence in MACD can take the form of either a lower high or a straight decline. Negative divergences are probably the least common of the three signals, but are usually the most reliable and can warn of an impending peak. Federal Express

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_MACD2-print.html (1 of 7) [2/18/2003 5:26:07 AM]

StockCharts.com - MACD Part 2

The FDX chart shows a negative divergence when MACD formed a lower high in May and the stock formed a higher high at the same time. This was a rather blatant negative divergence and signaled that momentum was slowing. A few days later, the stock broke the uptrend line and MACD formed a lower low. There are two possible means of confirming a negative divergence. First, the indicator can form a lower low. This is traditional peak-and-trough analysis applied to an indicator. With the lower high and subsequent lower low, the up trend for MACD has changed from bullish to bearish. Second, a bearish moving average crossover, which is explained below, can act to confirm a negative divergence. As long as MACD is trading above its 9-day EMA or trigger line, it has not turned down and the lower high is difficult to confirm. When MACD breaks below its 9-day EMA, it signals that the short-term trend http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_MACD2-print.html (2 of 7) [2/18/2003 5:26:07 AM]

StockCharts.com - MACD Part 2

for the indicator is weakening, and a possible interim peak has formed. Bearish moving average crossover The most common signal for MACD is the moving average crossover. A bearish moving average crossover occurs when MACD declines below its 9-day EMA. Not only are these signals the most common, but they also produce the most false signals. As such, moving average crossovers should be confirmed with other signals to avoid whipsaws and false readings. Merck

Sometimes a stock can be in a strong uptrend and MACD will remain above its trigger line for a sustained period of time. In this case, it is unlikely that a negative divergence http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_MACD2-print.html (3 of 7) [2/18/2003 5:26:07 AM]

StockCharts.com - MACD Part 2

will develop. A different signal is needed to identify a potential change in momentum. This was the case with MRK in February and March. The stock advanced in a strong up trend and MACD remained above its 9-day EMA for 7 weeks. When a bearish moving average crossover occurred, it signaled that upside momentum was slowing. This slowing momentum should have served as an alert to monitor the technical situation for further clues of weakness. Weakness was soon confirmed when the stock broke its uptrend line and MACD continued its decline and moved below zero. Bearish centerline crossover A bearish centerline crossover occurs when MACD moves below zero and into negative territory. This is a clear indication that momentum has changed from positive to negative, or from bullish to bearish. The centerline crossover can act as an independent signal, or confirm a prior signal such as a moving average crossover or negative divergence. Once MACD crosses into negative territory, momentum, at least for the short term, has turned bearish. Unisys

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_MACD2-print.html (4 of 7) [2/18/2003 5:26:07 AM]

StockCharts.com - MACD Part 2

The significance of the centerline crossover will depend on the previous movements of MACD as well. If MACD is positive for many weeks, begins to trend down and then crosses into negative territory, it would be considered bearish. However, if MACD has been negative for a few months, breaks above zero and then back below, it may be seen as more of a correction. In order to judge the significance of a centerline crossover, traditional technical analysis can be applied to see if there has been a change in trend, higher high or lower low. The UIS chart depicts a bearish centerline crossover that preceded a 25% drop in the stock that occurs just off the right edge of the chart. Although there was little time to act once this signal appeared, there were other warnings signs just prior to the dramatic drop. 1. After the drop to trendline support , a bearish moving average crossover formed. 2. When the stock rebounded from the drop, MACD did not even break above the trigger line, indicating weak upside momentum. 3. The peak of the reaction rally was marked by a shooting star candlestick (blue arrow) and a gap down on increased volume (red arrows). 4. After the gap down, the blue trendline extending up from Apr-99 was broken. In addition to the signal mentioned above, the bearish centerline crossover occurred after MACD had been above zero for almost two months. Since 20-Sept, MACD had been weakening and momentum was slowing. The break below zero acted as the final straw of a long weakening process. Combining Signals

As with bullish MACD signals, bearish signals can be combined to create more robust signals. In most cases, stocks fall faster than they rise. This was definitely the case with UIS and only two bearish MACD signals were present. Using momentum indicators like MACD, technical analysis can sometimes provide clues to impending weakness. While it may be impossible to predict the length and duration of the decline, being able to spot weakness can enable traders to take a more defensive position.

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_MACD2-print.html (5 of 7) [2/18/2003 5:26:07 AM]

StockCharts.com - MACD Part 2

After issuing a profit warning in late Feb-00, CPQ dropped from above 40 to below 25 in a few months. Without inside information, predicting the profit warning would be pretty much impossible. However, it would seem that smart money began distributing the stock before the actual warnings. Looking at the technical picture, we can spot evidence of this distribution and a serious loss of momentum. 1. In January, a negative divergence formed in MACD. 2. Chaikin Money Flow turned negative on January 21. 3. Also in January, a bearish moving average crossover occurred in MACD (black arrow). 4. The trendline extending up from October was broken on 4-Feb. 5. A bearish centerline crossover occurred in MACD on 10-Feb (green arrow). http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_MACD2-print.html (6 of 7) [2/18/2003 5:26:07 AM]

StockCharts.com - MACD Part 2

6. On 16, 17 and 18-Feb, support at 41 1/2 was violated (red arrow). A full 10 days passed in which MACD was below zero and continued to decline (thin red lines). The day before the gap down, MACD was at levels not seen since October. For those waiting for a recovery in the stock, the continued decline of momentum suggested that selling pressure was increasing, and not about to decrease. Hindsight is 20/20, but with careful study of past situations, we can learn how to better read the present and prepare for the future. In Part 3, we look at some of the benefits and drawbacks of MACD.

Written by Arthur Hill Part 1 | Part 2 | Part 3 | Part 4

Send us your Feedback!

©2002 StockCharts.com All Rights Reserved Terms of Use

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_MACD2-print.html (7 of 7) [2/18/2003 5:26:07 AM]

StockCharts.com - MACD Part 3

MACD Part 3

MACD Benefits

One of the primary benefits of MACD is that it incorporates aspects of both momentum and trend in one indicator. As a trend-following indicator, it will not be wrong for very long. The use of moving averages ensures that the indicator will eventually follow the movements of the underlying security. By using exponential moving averages, as opposed to simple moving averages, some of the lag has been taken out. As a momentum indicator, MACD has the ability to foreshadow moves in the underlying security. MACD divergences can be key factors in predicting a trend change. A negative divergence signals that bullish momentum is waning and there could be a potential change in trend from bullish to bearish. This can serve as an alert for traders to take some profits in long positions, or for aggressive traders to consider initiating a short position. MACD can be applied to daily, weekly or monthly charts. MACD represents the convergence and divergence of two moving averages. The standard setting for MACD is the difference between the 12 and 26-period EMA. However, any combination of moving averages can be used. The set of moving averages used in MACD can be tailored for each individual security. For weekly charts, a faster set of moving averages may be appropriate. For volatile stocks, slower moving averages may be needed to help smooth the data. No matter what the characteristics of the underlying security, each individual can set MACD to suit his or her own trading style, objectives and risk tolerance. MACD Drawbacks

One of the beneficial aspects of MACD may also be a drawback. Moving averages, be they simple, exponential or weighted, are lagging indicators. Even though MACD represents the difference between two moving averages, there can still be some lag in the indicator itself. This is more likely to be the case with weekly charts than daily charts. One solution to this problem is the use of the MACD-Histogram. MACD is not particularly good for identifying overbought and oversold levels. Even though it is possible to identify levels that historically represent overbought and oversold levels, MACD does not have any upper or lower limits to bind its movement. MACD can continue to overextend beyond historical extremes. http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_MACD3-print.html (1 of 4) [2/18/2003 5:26:16 AM]

StockCharts.com - MACD Part 3

MACD calculates the absolute difference between two moving averages and not the percentage difference. MACD is calculated by subtracting one moving average from the other. As a security increases in price, the difference (both positive and negative) between the two moving averages is destined to grow. This makes its difficult to compare MACD levels over a long period of time, especially for stocks that have grown exponentially. Amazon

The AMZN chart demonstrates the difficult in comparing MACD levels over a long period of time. Before 1999, AMZN's MACD is barely recognizable and appears to trade close to the zero line. MACD was indeed quite volatile at the time, but this volatility has been http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_MACD3-print.html (2 of 4) [2/18/2003 5:26:16 AM]

StockCharts.com - MACD Part 3

dwarfed since the stock rose from below 20 to almost 100. An alternative is to use the Price Oscillator, which find the percentage difference between two moving averages: (12 day EMA - 26 day EMA) / (12 day EMA) (20 - 18) / 20 = .10 or +10% The resulting percentage difference can be compared over a longer period of time. On the AMZN chart, we can see that the Price Oscillator provides a better means for a longterm comparison. For the short term, MACD and the Price Oscillator are basically the same. The shape of the lines, the divergences, moving average crossovers and centerline crossovers for MACD and the Price Oscillator are virtually identical. MACD Conclusion

Since Gerald Appel developed MACD, there have been hundreds of new indicators introduced to technical analysis. While many indicators have come and gone, MACD is an oscillator that has stood the test of time. The concept behind its use is straightforward and its construction simple, yet it remains one of the most reliable indicators around. The effectiveness of MACD will vary for different securities and markets. The lengths of the moving averages can be adapted for a better fit to a particular security or market. As with all indicators , MACD is not infallible and should be used in conjunction with other technical analysis tools. In Part 4, we examine the benefits and drawbacks of MACD-Histogram.

Written by Arthur Hill Part 1 | Part 2 | Part 3 | Part 4

Send us your Feedback!

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_MACD3-print.html (3 of 4) [2/18/2003 5:26:16 AM]

StockCharts.com - MACD Part 3

©2002 StockCharts.com All Rights Reserved Terms of Use

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_MACD3-print.html (4 of 4) [2/18/2003 5:26:16 AM]

StockCharts.com - MACD Part 4

MACD Part 4

MACD-Histogram

In 1986, Thomas Aspray developed the MACD-Histogram. Some of his findings were presented in a series of articles for Technical Analysis of Stocks and Commodities. Aspray noted that MACD would sometimes lag important moves in a security, especially when applied to weekly charts. He first experimented by changing the moving averages and found that shorter moving averages did indeed speed up the signals. However, he was looking for a means to anticipate MACD crossovers. One of the answers he came up with was the MACD-Histogram. MACD

Definition and Construction

The MACD-Histogram represents the difference between MACD and the 9-day EMA of MACD, which can also be referred to as the signal or trigger line. The plot of this difference is presented as a histogram, making centerline crossovers and divergences are easily identifiable. A centerline crossover for the MACD-Histogram is the same as a http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_MACD4-print.html (1 of 9) [2/18/2003 5:26:29 AM]

StockCharts.com - MACD Part 4

moving average crossover for MACD. If you will recall, a moving average crossover occurs when MACD moves above or below the signal line. If the value of MACD is larger than the value of its 9-day EMA, then the value on the MACD-Histogram will be positive. Conversely, if the value of MACD is less than its 9-day EMA, then the value on the MACD-Histogram will be negative. Further increases or decreases in the gap between MACD and its 9-day EMA will be reflected in the MACD-Histogram. Sharp increases in the MACD-Histogram indicate that MACD is rising faster than its 9-day EMA and bullish momentum is strengthening. Sharp declines in the MACD-Histogram indicate that MACD is falling faster than its 9-day EMA and bearish momentum is increasing. MACD

On the chart above, we can see that MACD-Histogram movements are relatively independent of the actual MACD. Sometimes MACD is rising while the MACD-Histogram is falling. At other times, MACD is falling while MACD-Histogram is rising. MACDHistogram does not reflect the absolute value of MACD, but rather the value of MACD relative to its 9-day EMA. Usually, but not always, a move in MACD is preceded by a corresponding divergence in MACD-Histogram. 1. The first point shows a sharp positive divergence in MACD-Histogram that preceded a bullish moving average crossover. 2. On the second point, MACD continued to new highs, but MACD-Histogram formed

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_MACD4-print.html (2 of 9) [2/18/2003 5:26:29 AM]

StockCharts.com - MACD Part 4

two equal highs. Although not a textbook positive divergence, the equal high failed to confirm the strength seen in MACD. 3. A positive divergence formed when MACD-Histogram formed a higher low and MACD continued lower. 4. A negative divergence formed when MACD-Histogram formed a lower high and MACD continued higher. Usage

Thomas Aspray designed the MACD-Histogram as a tool to anticipate a moving average crossover in MACD. Divergences between MACD and the MACD-Histogram are the main tool used to anticipate moving average crossovers. A positive divergence in the MACDHistogram indicates that MACD is strengthening and could be on the verge of a bullish moving average crossover. A negative divergence in the MACD-Histogram indicates that MACD is weakening and can act to foreshadow a bearish moving average crossover in MACD. In his book, Technical Analysis of the Financial Markets, John Murphy asserts that the MACD-Histogram is best used to identify periods when the gap between MACD and its 9day EMA is either widening or shrinking. Broadly speaking, a widening gap indicates strengthening momentum and a shrinking gap indicates weakening momentum. Usually a change in the MACD-Histogram will precede any changes in MACD. Signals

The main signal generated by the MACD-Histogram is a divergence followed by a moving average crossover. A bullish signal is generated when a positive divergence forms and there is a bullish centerline crossover. A bearish signal is generated when there is a negative divergence and a bearish centerline crossover. Keep in mind that a centerline crossover for the MACD-Histogram represents a moving average crossover for MACD. Divergences can take many forms and varying degrees. Generally speaking, two types of divergences have been identified: the slant divergence and the peak-trough divergence. Unisys

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_MACD4-print.html (3 of 9) [2/18/2003 5:26:29 AM]

StockCharts.com - MACD Part 4

A slant divergence forms when there is a continuous and relatively smooth move in one direction (up or down) to form the divergence. Slant divergences generally cover a shorter timeframe than divergences formed with two peaks or two troughs. A slant divergence can contain some small bumps (peaks or troughs) along the way. The world of technical analysis is not perfect and there are exceptions to most rules and hybrids for many signals. General Electric

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_MACD4-print.html (4 of 9) [2/18/2003 5:26:29 AM]

StockCharts.com - MACD Part 4

A peak-trough divergence occurs when at least two peaks or two troughs develop in one direction to form the divergence. A series of two or more rising troughs (higher lows) can form a positive divergence and a series of two or more declining peaks (lower highs) can form a negative divergence. Peak-trough divergences usually cover a longer timeframe than slant divergences. On a daily chart, a peak-trough divergence can cover a timeframe as short as two weeks or as long as several months. Usually, the longer and sharper the divergence is, the better any ensuing signal will be. Short and shallow divergences can lead to false signals and whipsaws. In addition, it would appear that peak-trough divergences are a bit more reliable than slant divergences. Peak-trough divergences tend to be sharper and cover a longer time frame than slant divergences. http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_MACD4-print.html (5 of 9) [2/18/2003 5:26:29 AM]

StockCharts.com - MACD Part 4

MACD-Histogram Benefits

The main benefit of the MACD-Histogram is its ability to anticipate MACD signals. Divergences usually appear in the MACD-Histogram before MACD moving average crossovers. Armed with this knowledge, traders and investors can better prepare for potential trend changes. MACD-Histogram can be applied to daily, weekly or monthly charts. (Note: This may require some tinkering with the number of periods used to form the original MACD; shorter or faster moving averages may be required for weekly and monthly charts.) Using weekly charts, the broad underlying trend of a stock can be determined. Once the broad trend has been determined, daily charts can be used to time entry and exit strategies. In Technical Analysis of the Financial Markets, John Murphy advocates this type of twotiered approach to investing in order to avoid making trades against the major trend. The weekly MACD-Histogram can be used to generate a long-term signal in order to establish the tradable trend. Then only short-term signals that jibe with the major trend are eligible for use. If the long-term trend were bullish, only positive divergences with bullish centerline crossovers would be considered valid for the MACD-Histogram. If the long-term trend were bearish, only negative divergences with bearish centerline crossovers would be considered valid. IBM

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_MACD4-print.html (6 of 9) [2/18/2003 5:26:29 AM]

StockCharts.com - MACD Part 4

On the IBM weekly chart, the MACD-Histogram generated four signals. Before each moving average crossover in MACD, a corresponding divergence formed in the MACDHistogram. To make adjustments for the weekly chart, the moving averages have been shortened to 6 and 12. This MACD is formed by subtracting the 6-week EMA from the 12-week EMA. A 6-week EMA has been used as the trigger. The MACD-Histogram is calculated by taking the difference between MACD (6/12) and the 6-day EMA of MACD (6/12). 1. The first signal was a bearish moving average crossover in Jan-99. From its peak in late Nov-98, the MACD-Histogram formed a negative divergence that preceded the bearish moving average crossover in MACD. 2. The second signal was a bullish moving average crossover in April. From its low in http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_MACD4-print.html (7 of 9) [2/18/2003 5:26:29 AM]

StockCharts.com - MACD Part 4

mid-February, the MACD-Histogram formed a positive divergence that preceded the bullish moving average crossover in MACD. 3. The third signal was a bearish moving average crossover in late July. From its May peak, the MACD-Histogram formed a negative divergence that preceded a bearish moving average crossover in MACD. 4. The final signal was a bullish moving average crossover, which was preceded by a slight positive divergence in MACD-Histogram. The third signal was based on a peak-trough divergence. Two readily identifiable and consecutive lower peaks formed to create the divergence. The peaks and troughs on the previous divergences, although identifiable, do not stand out as much. MACD-Histogram Drawbacks

The MACD-Histogram is an indicator of an indicator or a derivative of a derivative. MACD is the first derivative of the price action of a security and the MACD-Histogram is the second derivative of the price action of a security. As the second derivative, the MACD-Histogram is further removed from the actual price action of the underlying security. The further removed an indicator is from the underlying price action, the greater the chances of false signals. Keep in mind that this is an indicator of an indicator. MACD-Histogram should not be compared directly with the price action of the underlying security. Because MACD-Histogram was designed to anticipate MACD signals, there may be a temptation to jump the gun. The MACD-Histogram should be used in conjunction with other aspects of technical analysis. This will help to alleviate the temptation for early entry. Another means to guard against early entry is to combine weekly signals with daily signals. There will of course be more daily signals than weekly signals. However, by using only the daily signals that agree with the weekly signals, there will be fewer daily signals to act on. By acting only on those daily signals that are in agreement with the weekly signals, you are also assured of trading with the longer trend and not against it. Be careful of small and shallow divergences. While these may sometimes lead to good signals, they are also more apt to create false signals. One method to avoid small divergences is to look for larger divergences with two or more readily identifiable peaks or troughs. Compare the peaks and troughs from past action to determine significance. Only peaks and troughs that appear to be significant should warrant attention. MACD and SharpCharts

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_MACD4-print.html (8 of 9) [2/18/2003 5:26:29 AM]

StockCharts.com - MACD Part 4

Using SharpCharts, MACD can be set as an indicator above or below a security's price plot. Once the indicator is chosen from the drop down list, the three boxes to the right are used to adjust the settings. The default setting is (12,26,9), which automatically appears. The default would use a 12-day EMA and 26-day EMA to calculate MACD and a 9-day EMA of MACD as the signal/trigger line. MACD appears as the thick solid line and the signal/trigger line as the thinner and smoother line. Typically, MACD crosses above and below its signal line as it fluctuates around the zero line. The histogram is the MACDHistogram, which measures the difference between MACD and its signal/trigger line. The scale shows the range of values for MACD. Stocks with low prices (eg between 10 and 20) will have a smaller MACD range and stocks with high prices (eg above 100) will have a higher MACD range. Want more on indicators? See our overview article.

Written by Arthur Hill Part 1 | Part 2 | Part 3 | Part 4

Send us your Feedback!

©2002 StockCharts.com All Rights Reserved Terms of Use

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_MACD4-print.html (9 of 9) [2/18/2003 5:26:29 AM]

StockCharts.com - Percentage Volume Oscillator (PVO)

Percentage Volume Oscillator (PVO) The Percentage Volume Oscillator (PVO) is the percentage difference between two moving averages of volume. The indicator is calculated with the following formula: Volume Oscillator (%) - PVO = ((Vol 12-day EMA - Vol 26-day EMA)/Vol 12day EMA) x 100 The 12-day exponential moving average (EMA) and 26-exponential moving average were used as examples. Typically, these can be changed to suit longer or shorter time periods. Because of its formula, the PVO has a maximum value of +100, but no minimum value. For example: if the 12-day EMA equals 2000 and the 26-day EMA equals 8000, then the PVO would equal -300 (((2000 - 8000)/2000) x 100) = -300. The absolute value is not as important as the direction or the crosses above and below the zero line. Uses The PVO can be used to identify periods of expanding or contracting volume in three different ways: ●

●

●

Centerline Crossovers: like the PPO, the PVO oscillates above and below the zero line. When PVO is positive, the shorter EMA of volume is greater than the longer EMA of volume. When PVO is negative, the shorter EMA of volume is less than the longer EMA of volume. A PVO above zero indicates that volume levels are generally above average and relatively heavy. When the PVO is below zero, volume levels are generally below average and light. Directional Movement: General directional movement of the PVO can offer a quick visual assessment of volume patterns. A rising PVO signals that volume levels are increasing and a falling PVO signals that volume levels are decreasing. Moving average crossovers: The last variable in the PVO forms the signal line. For example: PVO(12,26,9) would include a 9-day EMA of PVO as well as a histogram representing the difference between the PVO and its 9-day EMA. When PVO moves above its signal line, volume levels are generally increasing. When PVO moves below its signal line, volume levels are generally decreasing.

Movements in the PVO are completely separate from price movements. As such, movements in PVO can correlated with price movements to assess the degree of buying or selling pressure. Advances combined with strength in the PVO would be considered strong. Should the PVO decline while a security's price fell, it would indicate decreasing http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_PVO-print.html (1 of 5) [2/18/2003 5:26:40 AM]

StockCharts.com - Percentage Volume Oscillator (PVO)

volume on the decline.

In the example above, FILE is shown with two PVO settings: PVO (12,26,9) in the top window and PVO (5,60,1) in the bottom window. When the final variable is set at 1, as with PVO(5,60,1) there is no signal line or histogram. During August and September, the stock traded between 15 and 21, and the PVO remained mostly below zero. There was a small bounce above zero with the late August advance, but the stock remained confined to its trading range. When the stock began to advance off of its low in October, the PVO moved into positive territory with a sharp rise (green line). The advance was confirmed with expanding volume and the stock broke resistance. The breakout with expanding volume signaled exceptionally strong buying pressure. http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_PVO-print.html (2 of 5) [2/18/2003 5:26:40 AM]

StockCharts.com - Percentage Volume Oscillator (PVO)

The Percentage Volume Oscillator (PVO) and SharpCharts

On SharpCharts, the PVO has three variable boxes and appears in the same format as the Percentage Price Oscillator (PPO). The default setting is (12,26,9): the first variable is for the short exponential moving average (EMA) of volume, the second is for the long exponential moving average of volume and the third is for the signal line. The signal line is the EMA of the indicator itself (the PVO) and can also be made longer or shorter. The histogram (solid area above and below zero) represents the difference between the PVO and its signal line. For those who do not wish to have a trigger line or histogram, the third variable (the signal line) can be set equal to 1.

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_PVO-print.html (3 of 5) [2/18/2003 5:26:40 AM]

StockCharts.com - Percentage Volume Oscillator (PVO)

In the example above, the PVO is set in the top window at the default setting (12,26,9) and in the bottom window at (5,60,1). Even though the line shapes for both PVO settings are almost identical, the scales on the right reflect different ranges and crossover points. ● ●

●

PVO (12,26,9) surpassed +20 in late October, while PVO (5,60,1) surpassed +50. In early October (red line #1), PVO (5,60,1) crossed below zero, but PVO (12,26,9) remained above. At the beginning of December (red line #2), PVO (5,60,1) moved above zero before PVO (12,26,9) did.

Much of this difference can be attributed to the short EMA of volume in both PVO settings. The 5-day EMA of volume is much more sensitive than the 12-day EMA of http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_PVO-print.html (4 of 5) [2/18/2003 5:26:40 AM]

StockCharts.com - Percentage Volume Oscillator (PVO)

volume. Shorter moving averages are more volatile and more likely to have centerline crossovers. Above-average volume periods can also be confirmed by watching for volume bars that exceed the 60-day EMA (green oval in October). Notice that both PVOs shot up in the second half of October as volume spiked above 60m shares.

Written by Arthur Hill

Send us your Feedback!

©2002 StockCharts.com All Rights Reserved Terms of Use

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_PVO-print.html (5 of 5) [2/18/2003 5:26:40 AM]

StockCharts.com - Price Oscillator

Price Oscillator

Introduction

The Price Oscillator is an indicator based on the difference between two moving averages, and is expressed as either a percentage or in absolute terms. According to user preferences, the moving averages used to calculate the Price Oscillator can be exponential, weighted or simple and the number of time periods can vary. For daily data, longer moving averages might be preferred to filter out some of the randomness associated with daily prices. For weekly data, which will have already filtered out some of the randomness, shorter moving averages may be deemed more appropriate. In addition, a moving average of the ensuing plot can be overlaid to act as a trigger line, much like is done with MACD. In our charts and commentary, we will use the abbreviation PPO to refer to the Percentage Price Oscillator and APO to refer to the Absolute Price Oscillator. Absolute Price Oscillator (APO)

The Absolute Price Oscillator is calculated by subtracting the longer moving average from the shorter moving average. For example:

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_priceOscillator-print.html (1 of 8) [2/18/2003 5:26:54 AM]

StockCharts.com - Price Oscillator

10-period exponential moving average (EMA) minus 30-period EMA The resulting plot forms an oscillator that fluctuates above and below zero according to the differences in the moving averages. If the shorter moving average is above the longer moving average, then the indicator will be positive. If the shorter moving average is below the longer moving average, then the indicator will be negative. Note: MACD is also calculated by finding the absolute difference. Theoretically, MACD can be calculated with any two user-defined moving averages. However, it is typically calculated by subtracting the 26-day exponential moving average from the 12-day exponential moving average. Percentage Price Oscillator (PPO)

The Percentage Price Oscillator is found by subtracting the longer moving average from the shorter moving average and then dividing the result by the shorter moving average. For example:

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_priceOscillator-print.html (2 of 8) [2/18/2003 5:26:54 AM]

StockCharts.com - Price Oscillator

(Click here to see a live example of PPO) {(10-period EMA minus 30-period EMA) divided by the 10-period EMA} This formula displays the difference between the two moving averages as a percentage of the shorter moving average. Absolute versus Percentage

The Percentage Price Oscillator (PPO) and the Absolute Price Oscillator (APO) generate many of the same signals and have basically the same shape. All centerline crossovers, which represent the shorter moving average crossing above or below the longer moving average, occur at the same time. However, because the shape of the lines are not exactly identical, there will likely be discrepancies. This analysis of the Nasdaq Composite illustrates some of the differences that may crop up.

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_priceOscillator-print.html (3 of 8) [2/18/2003 5:26:54 AM]

StockCharts.com - Price Oscillator

1. The green circle shows that the PPO formed a lower high in December while the APO formed a higher high. 2. Later in December, the APO continued higher and the PPO began to flatten out. (red arrows) 3. In early January, the PPO recorded a lower low, which was a day earlier than the APO. There are two main reasons for using the PPO versus the APO. 1. With the Percentage Price Oscillator, it is possible to compare Price Oscillator levels from one security to the next. A PPO reading of +5% means that the shorter moving average is 5% higher than the longer moving average. This http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_priceOscillator-print.html (4 of 8) [2/18/2003 5:26:54 AM]

StockCharts.com - Price Oscillator

percentage reading is comparable against another security, regardless of the price of a security. The Percentage Price Oscillator (PPO) for SLB only reached 3% for its highs while that of the Nasdaq Composite rose above 7%.

2. The Percentage Price Oscillator is a better representation of the two moving averages relative to each other. The difference between the two moving averages is shown in relation to the shorter moving average. This allows for comparisons across time periods, regardless of the price of the stock. With the Absolute Price Oscillator, the higher the price of the stock, the greater the extremes of the oscillator. With the Percentage Price Oscillator, a comparison of Amazon over time is possible regardless of whether the stock is at 10 or 100.

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_priceOscillator-print.html (5 of 8) [2/18/2003 5:26:54 AM]

StockCharts.com - Price Oscillator

PPO-Histogram

The daily Percentage Price Oscillator, using 12 and 26-day EMAs, is very similar to the standard MACD, which also uses the 12 and 26-day EMAs. The Percentage Price Oscillator measures the difference between the two moving averages as a percentage of the shorter moving average. Because the Price Oscillator and MACD are so similar, the concept of the MACDHistogram has been applied to the PPO. The PPO-Histogram shows the difference between the PPO and the 9-day EMA of the PPO. The plot is presented as a histogram so that centerline crossovers and divergences are easily identifiable. The same http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_priceOscillator-print.html (6 of 8) [2/18/2003 5:26:54 AM]

StockCharts.com - Price Oscillator

principles that apply to the MACD-Histogram are also applicable to the PPO-Histogram. The Absolute Price Oscillator (APO) is exactly the same as the MACD. A centerline crossover for the PPO-Histogram is the same as a moving average crossover for the PPO. If the value of the PPO is larger than the value of its 9-day EMA, then the value on the PPO-Histogram will be positive. Conversely, if the value of the PPO is less than its 9-day EMA, then the value of the PPO-Histogram will be negative.

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_priceOscillator-print.html (7 of 8) [2/18/2003 5:26:54 AM]

StockCharts.com - Price Oscillator

Further increases or decreases in the gap between the PPO and its 9-day EMA will be reflected in the PPO-Histogram. Sharp increases in the PPO-Histogram indicate that the PPO is rising faster than its 9-day EMA -- bullish momentum is strengthening. Sharp declines in the PPO-Histogram indicate that the PPO is falling faster than its moving average -- bearish momentum is increasing. For more on the interpretation of this oscillator and its signals, see our articles about oscillators and MACD.

Written by Arthur Hill

Send us your Feedback!

©2002 StockCharts.com All Rights Reserved Terms of Use

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_priceOscillator-print.html (8 of 8) [2/18/2003 5:26:54 AM]

StockCharts.com - Price Relative

Price Relative The Price Relative compares the performance of one security against that of another. It is often used to compare the performance of a particular stock to a market index, usually the S&P 500. Because the goal of many portfolio managers is to outperform the S&P 500, they are usually interested in the strongest stocks. The price relative offers a straightforward and accurate portrayal of a stock's performance relative to the market. The price relative is calculated by dividing the security's price by the value of the S&P 500. If WMT were trading at 60 and the S&P 500 were 1400, then the price relative would be 60/1400, which equals .0428. Should WMT advance to 70 and the S&P 500 to 1450, the price relative would be .0482 (70/1450). The advance from .0428 to .0482 shows the WMT is stronger than the S&P 500. This number is then plotted along the Yaxis to form a line chart. The price relative can be calculated on a daily, weekly or monthly basis; closing prices are normally used. Traditional technical analysis techniques can be used to analyze the plot of the price relative. Support, resistance, trendlines, moving averages and pattern analysis can all be applied. Some analysts even apply indicators to the price relative in an attempt to identify changes.

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_priceRelative-print.html (1 of 4) [2/18/2003 5:27:09 AM]

StockCharts.com - Price Relative

(Click here to see a live example of Price Relative) In the WMT chart, we can see that the price relative peaked on 16-Dec (red line), about two weeks earlier than the stock. A series of lower highs ensued, and short-term support was broken in mid-January. A few days later, the price relative broke its trendline extending up from early August (blue line). The support and trendline breaks in the stock occurred later than those in the price relative. A sharp decline in the stock was foreshadowed by weakness in the price relative.

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_priceRelative-print.html (2 of 4) [2/18/2003 5:27:09 AM]

StockCharts.com - Price Relative

In the 1998 chart for SUNW, the price relative recorded a higher low in August and a new reaction high in September (black arrow). This created a positive divergence and signaled that SUNW was much stronger than the overall market. When the October1998 rally kicked in, SUNW was one of the top performers over the next 17 months. Rotation among sectors and stocks plays a big part in today's market. By applying the price relative to industry groups and stocks, traders and investors can identify pockets of relative strength and relative weakness. As with most indicators and analysis techniques, the price relative is just one tool and should be used in conjunction with other aspects of technical analysis. Sharp Charts and the Price Relative

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_priceRelative-print.html (3 of 4) [2/18/2003 5:27:09 AM]

StockCharts.com - Price Relative

The price relative for SharpCharts can displayed above or below the price plot of the underlying security. The first box to the right can be used to change the symbol -- any security can be entered here. For example, if the underlying security was the Amex Oil Index ($XOI) and you wanted to plot a price relative against West Texas Intermediate Crude ($WTIC), then $WTIC would be entered into the box. An advancing price relative would indicate that $XOI was outperforming $WTIC and a declining price relative would show underperformance relative to $WTIC.

Written by Arthur Hill

Send us your Feedback!

©2002 StockCharts.com All Rights Reserved Terms of Use

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_priceRelative-print.html (4 of 4) [2/18/2003 5:27:09 AM]

Rabbitt Analytics Methodology

Q-Look Analysis (Enter stock ticker) Go

Q-Rank Methodology What is it made of? How Do You Use It? An Analogy What It Isn’t Technical Jargon- how we set the weight of each item How We Decide What to Follow What is it made of? The Q-Rank is a combination of nine fundamental and technical models for each stock. The scores range from 99 (highest) to 1 (lowest); i.e., a stock with a Q-Rank of 99 has combined qualities better than 99% of the stocks measured. It combines a Technical Sub-rank (TSR) and an Earnings Sub-rank (ESR) which offer further insight into the qualities influencing the total Q-Rank. We would buy stocks with a Q-Rank ranks above 70 (even better though if Q-Rank is above 90) and avoid those below 50.

Today's Market

The Technical SubRank (TSR) combines four models rewarding price leadership, trading status, longterm trend, and sector attractiveness. The relative strength indicator compares the price performance of each stock over the past four quarters to that of all 3,000 stocks in our Q-Rank universe. A relative strength score of 99 indicates that the stock's price performance in the past four quarters was better than 99% of the quantitative universe. Although the relative strength score looks at leadership for the past four quarters, the most recent quarter gets increased importance. Return reversal reflects the tendency of stocks to get overbought or oversold. It is for short-term traders only. It is based upon a stock's price change over the preceding two weeks. Stocks with higher returns in the prior two weeks

http://rabbittanalytics.com/methodology.htm (1 of 4) [2/18/2003 5:27:50 AM]

Rabbitt Analytics Methodology

get low scores because they tend to "reverse" and under-perform over the subsequent two weeks. Return reversal scores greater than 90 suggest potential short-term outperformance. Stocks with scores below 10 have usually skyrocketed recently and are likely to consolidate their gains, falling back to their long-term trends. A price/200-day moving average ratio is used to identify a stock's trend, and sometimes whether investors have discounted its price too optimistically or pessimistically1. It is positive above 120%, negative below 90%. The industry combo model measures the attractiveness of a company’s respective industry based on consensus Wall Street earnings revisions and surprise, price/relative strength, price/book ratio, price/cash-flow ratio, price/sales ratio, and dividend yield. We find the top 25% of these industries attractive and would tend to underweight the bottom 25%. The Earnings Sub-rank (ESR) combines value and growth characteristics divided into four categories. It rewards or penalizes companies based on Wall Street consensus earnings revisions, earnings surprises, earnings consistency, earnings growth/acceleration, and reasonable valuations. Earnings surprise is the difference between the most recent actual reported earnings and Wall Streets' consensus earnings estimates (standard SUI calculation). Earnings Revision measures the past month change in Wall Streets' consensus earnings estimates of the company's one-year earnings estimate. Earnings acceleration identifies companies with rising earnings growth over the previous four years that will likely generate rising earnings growth rates for the next two years according to consensus expectations. It rewards companies demonstrating above trendline rates of growth. Earnings consistency identifies companies that have positive earnings over the prior three years that demonstrate low earnings volatility. It is a ranking of two combined parameters: 1) The number of quarters in the last 12 in which the company's earnings were positive; 2) The volatility of the earnings stream during the period. Return on equity identifies companies with an ROE significantly different from the overall universe. EPS Growth is based on consensus Wall Street earnings estimates for the company's next fiscal year. P/E is the price/earnings ratio based on next year's consensus earnings estimate. Growth to P/E compares the average expected earnings growth rate over the next two years to an average P/E based on those earnings. How Do You Use It? An Analogy (Back to Top) The Q-Rank model is like a research assistant: It allows you to follow a larger universe http://rabbittanalytics.com/methodology.htm (2 of 4) [2/18/2003 5:27:50 AM]

Rabbitt Analytics Methodology

of stocks. This assistant reviews 3,000 stocks every night and reflects an opinion in a consistent, objective, and easy-to-understand form. The assistant allows you to focus on more detailed, specific research. The assistant gives an independent second opinion on your own buy/sell candidates, regularly surveys your stock watch list, identifies new buy/sell candidates, screens for specific factors such as earnings revisions, and delivers ideas within sectors or industries. The Q-Rank is a starting point that identifies stocks to which you may then apply your own experience, insights, judgment, and knowledge. Q-Rank can improve timing by delaying purchases or sales that may be just a little too early. Q-Rank stocks ranked above 90 tend to significantly outperform the market; those under 10 tend to significantly under-perform. We believe investors considering buying a stock with a Q-Rank under 50 should delay purchase unless the stock offers an extremely solid value, new product and/or turnaround story. Investors considering selling a stock with a Q-Rank over 90 should consider holding the stock until its rank declines. The Q-Rank is meant to assist pure fundamental research, not replace it. We always recommend sound fundamental judgment in addition to our quantitative approach. Regardless of style, the overlay of a Q-Rank rank should improve performance. For example, a value investor can use the Q-Rank to stay in value stocks that have performed so well they may no longer represent good value but may just be hitting a strong momentum phase. What It Isn’t (Back to Top) Q-Rank is not a "paint-by-numbers" for managing money. The Q-Rank performance results illustrate the predictive power and risk of the model only. Used in isolation, the Q-Rank model could result in high turnover rates. Also, the Q-Rank ranks will often reflect concentrations in specific industry groups and economic sectors. Our experience shows the Q-Rank can help you by complementing—not replacing—your other stock research. Technical Jargon- how we set the weight of each item (Back to Top) Factor weights are computed based on relative return spreads over the last twelve months. We use the analytic hierarchy process (AHP) which is based on the concepts and techniques of hierarchical structuring, pair-wise comparisons, redundant judgments, and application of eigenvalues and eigenvector methodology to derive weights and consistency measures. The objective of pair-wise comparisons is to help the decisionmaker evaluate the weights on a rational basis. The redundant pair-wise comparisons enable accurate capturing of the decision-maker’s subjective evaluations. How We Decide What to Follow (Back to Top) The Q-Rank includes equities traded on the NYSE, AMEX, and NASDAQ, but excludes those with (1) market capitalization below $200 million; (2) a current price less than $6 per share; and (3) insufficient financial information. These initial criteria

http://rabbittanalytics.com/methodology.htm (3 of 4) [2/18/2003 5:27:50 AM]

Rabbitt Analytics Methodology

are flexible. Our goal is to keep the Q-Rank stock universe to a manageable size—about 3,000 securities. For more details, email a request to us.

Home | Search | Contact Us | Sign Up | Free Demo This site Copyright © 1998-2002 Rabbitt Analytics. Any use of this Web site is subject to the policies, disclaimers, and conditions set by Rabbitt Analytics. Read our legal statement and our privacy statement. Send mail to [email protected] with questions or comments about this web site. Last modified 12/18/02. This site maintained by Client Solutions, Inc.

http://rabbittanalytics.com/methodology.htm (4 of 4) [2/18/2003 5:27:50 AM]

StockCharts.com - Relative Strength Index (RSI)

Relative Strength Index (RSI)

Overview

Developed by J. Welles Wilder and introduced in his 1978 book, New Concepts in Technical Trading Systems, the Relative Strength Index (RSI) is an extremely useful and popular momentum oscillator. The RSI compares the magnitude of a stock's recent gains to the magnitude of its recent losses and turns that information into a number that ranges from 0 to 100. It takes a single parameter, the number of time periods to use in the calculation. In his book, Wilder recommends using 14 periods. The RSI's full name is actually rather unfortunate as it is easily confused with other forms of Relative Strength analysis such as John Murphy's "Relative Strength" charts and IBD's "Relative Strength" rankings. Most other kinds of "Relative Strength" stuff involve using more than one stock in the calculation. Like most true indicators, the RSI only needs one stock to be computed. In order to avoid confusion, many people avoid using the RSI's full name and just call it "the RSI."

Formula

To simplify the formula, the RSI has been broken down into its basic components which are the Average Gain, the Average Loss, the First RS, and the subsequent Smoothed RS's. http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_RSI-print.html (1 of 6) [2/18/2003 5:28:04 AM]

StockCharts.com - Relative Strength Index (RSI)

For a 14-period RSI, the Average Gain equals the sum total all gains divided by 14. Even if there are only 5 gains (losses), the total of those 5 gains (losses) is divided by the total number of RSI periods in the calculation (14 in this case). The Average Loss is computed in a similar manner. Calculation of the First RS value is straightforward: divide the Average Gain by the Average Loss. All subsequent RS calculations use the previous period's Average Gain and Average Loss for smoothing purposes. See the "Smoothed RS" formula above for details. The table below illustrates the formula in action.

(Click here for an Excel spreadsheet with this example in it.) Here's how lines 14 and 15 were calculated:

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_RSI-print.html (2 of 6) [2/18/2003 5:28:04 AM]

StockCharts.com - Relative Strength Index (RSI)

Note: It is important to remember that the Average Gain and Average Loss are not true averages! Instead of dividing by the number of gaining (losing) periods, total gains (losses) are always divided by the specified number of time periods - 14 in this case. When the Average Gain is greater than the Average Loss, the RSI rises because RS will be greater than 1. Conversely, when the average loss is greater than the average gain, the RSI declines because RS will be less than 1. The last part of the formula ensures that the indicator oscillates between 0 and 100. Important Note: The more data points that are used to calculate the RSI, the more accurate the results. The smoothing factor is a continuous calculation that - in theory takes into account all of the closing values in the dataset. If you start an RSI calculation in the middle of an existing dataset, your values will only approximate the true RSI value. SharpCharts uses at least 250 datapoints prior to the starting date of any chart (assuming that much data exists) when calculating its RSI values. To duplicate its RSI number, you'll need to use at least that much data also.

Use

Overbought/Oversold Wilder recommended using 70 and 30 and overbought and oversold levels respectively. Generally, if the RSI rises above 30 it is considered bullish for the underlying stock. Conversely, if the RSI falls below 70, it is a bearish signal. Some traders identify the long-term trend and then use extreme readings for entry points. If the long-term trend is bullish, then oversold readings could mark potential entry points. Divergences Buy and sell signals can also be generated by looking for positive and negative divergences between the RSI and the underlying stock. For example, consider a falling http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_RSI-print.html (3 of 6) [2/18/2003 5:28:04 AM]

StockCharts.com - Relative Strength Index (RSI)

stock whose RSI rises from a low point of (for example) 15 back up to say, 55. Because of how the RSI is constructed, the underlying stock will often reverse its direction soon after such a divergence. As in that example, divergences that occur after an overbought or oversold reading usually provide more reliable signals. Centerline Crossover The centerline for RSI is 50. Readings above and below can give the indicator a bullish or bearish tilt. On the whole, a reading above 50 indicates that average gains are higher than average losses and a reading below 50 indicates that losses are winning the battle. Some traders look for a move above 50 to confirm bullish signals or a move below 50 to confirm bearish signals. Example

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_RSI-print.html (4 of 6) [2/18/2003 5:28:04 AM]

StockCharts.com - Relative Strength Index (RSI)

(Click here to see a live example of RSI) The DELL example shows a number of extreme readings as well as a negative divergence. In Oct-99, RSI reached oversold for a brief moment to mark the low around 38. The next extreme reading (overbought) occurred after a large advance that peaked in Dec-99. RSI reached overbought levels in late Dec-99 and moved below 50 by the second week of Jan-00. The next oversold reading occurred in Feb for another brief moment and marked the low around 35. By the end of Feb-00, RSI moved back above 50 and into overbought territory in March. A negative divergence formed in March and marked the high in the upper fifties.

RSI and SharpCharts

RSI is available on our SharpCharts charting tool. There is one box to choose the number of periods. In the example box, RSI has been assigned 14, 20 and 30 periods. A swing trader might prefer 14-periods, while an investor may prefer 30-periods. Users are encouraged to test different RSI settings and judge for themselves which ones work best and suit their particular trading/investing style.

For more on oscillators, please see our Chart School article on how to use and interpret

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_RSI-print.html (5 of 6) [2/18/2003 5:28:04 AM]

StockCharts.com - Relative Strength Index (RSI)

oscillators.

Send us your Feedback!

©2002 StockCharts.com All Rights Reserved Terms of Use

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_RSI-print.html (6 of 6) [2/18/2003 5:28:04 AM]

StockCharts.com - Standard Deviation (volatility)

Standard Deviation (volatility) Standard deviation is a statistical term that provides a good indication of volatility. It measures how widely values (closing prices for instance) are dispersed from the average. Dispersion is difference between the actual value (closing price) and the average value (mean closing price). The larger the difference between the closing prices and the average price, the higher the standard deviation will be and the higher the volatility. The closer the closing prices are to the average price, the lower the standard deviation and the lower the volatility. The calculation for the standard deviation is based on the number of periods chosen. 20 days, which represents about a month, is a popular number of periods to use and will be used in the example below.

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_standardDev-print.html (1 of 5) [2/18/2003 5:28:17 AM]

StockCharts.com - Standard Deviation (volatility)

The steps for a 20-period standard deviation formula are as follows: 1. Calculate the mean price. Sum the 20 periods and divide by 20. This is also the average price over 20 periods. (2246.06/20 = 112.30) 2. For each period, subtract the mean price from the close. This gives us the deviation for each period (-3.30, -9.24….). 3. Square each period's deviation (10.91, 85.38…). http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_standardDev-print.html (2 of 5) [2/18/2003 5:28:17 AM]

StockCharts.com - Standard Deviation (volatility)

4. Add together the squared deviations for periods 1 through 20 (921.28). 5. Divide the sum of the squared deviations by 20 (921.28/20 = 46.06). 6. Calculate the square root of the sum of the squared deviations. The square root of 46.06 equals 6.787. The standard deviation for the 20 periods is 6.787. This example was formed with a price series for IBM. The chart below shows how the standard deviation can change over time.

After extended periods of consolidation, the standard deviation (or volatility) dropped. Notice that in late December the stock traded in a tight range and volatility dropped. Later in mid-March, the stock also traded in a tight range and volatility dropped. When the stock took off in the second half of March, volatility also rose.

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_standardDev-print.html (3 of 5) [2/18/2003 5:28:17 AM]

StockCharts.com - Standard Deviation (volatility)

VSTR, which is in the same price range as IBM, has a higher standard deviation. Until late December, the standard deviation was below 5. With the sharp advance in late December, the standard deviation rose from 5 to above 15. Since then it leveled out around 10 and has recently risen above 17. This is quite a volatile stock and its options will have more premium than IBM options. The higher the volatility for a particular stock, the higher the option premiums. The lower the volatility is for a particular stock, the lower the option premiums.

Written by Arthur Hill

Send us your Feedback!

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_standardDev-print.html (4 of 5) [2/18/2003 5:28:17 AM]

StockCharts.com - Standard Deviation (volatility)

©2002 StockCharts.com All Rights Reserved Terms of Use

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_standardDev-print.html (5 of 5) [2/18/2003 5:28:17 AM]

StockCharts.com - Stochastic Oscillator

Stochastic Oscillator

Overview

Developed by George C. Lane in the late 1950s, the Stochastic Oscillator is a momentum indicator that shows the location of the current close relative to the high/low range over a set number of periods. Closing levels that are consistently near the top of the range indicate accumulation (buying pressure) and those near the bottom of the range indicate distribution (selling pressure). Formula

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_stochasticOscillator-print.html (1 of 7) [2/18/2003 5:28:28 AM]

StockCharts.com - Stochastic Oscillator

A 14-day %K (14-period Stochastic Oscillator) would use the most recent close, the highest high over the last 14 days and the lowest low over the last 14 days. The number of periods will vary according to the sensitivity and the type of signals desired. As with RSI, 14 is a popular number of periods for calculation. %K tells us that the close (115.38) was in the 57th percentile of the high/low range, or just above the mid-point. Because %K is a percentage or ratio, it will fluctuate between 0 and 100. A 3-day simple moving average of %K is usually plotted alongside to act as a signal or trigger line, called %D.

Slow versus Fast versus Full

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_stochasticOscillator-print.html (2 of 7) [2/18/2003 5:28:28 AM]

StockCharts.com - Stochastic Oscillator

There are three types of Stochastic Oscillator: Fast, Slow, and Full. The Full Stochastic is discussed later. For now, let's look at Fast versus Slow. As shown above, the Fast Stochastic Oscillator is made up of %K and %D. In order to avoid confusion between the two, I'll use %K (fast) and %D (fast) to refer to those used in the Fast Stochastic Oscillator, and %K (slow) and %D (slow) to refer to those used in the Slow Stochastic Oscillator. The driving force behind both Stochastic Oscillators is %K (fast), which is found using the formula provided above.

(Click here to see a live example of Fast and Slow Stochastics) In the CSCO example, the Fast Stochastic Oscillator is plotted in the box just below the price plot. The thick black line represents %K (fast) and the thin red line represents %D (fast). Also called the trigger line, %D (fast) is a smoothed version of %K (fast). One http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_stochasticOscillator-print.html (3 of 7) [2/18/2003 5:28:28 AM]

StockCharts.com - Stochastic Oscillator

method of smoothing data is to apply a moving average. To smooth %K (fast) and create %D (fast), a 3-period simple moving average was applied to %K (fast). Notice how the %K (fast) line pierces the %D (fast) line a number of times during May, June and July. To alleviate some of these false breaks and smooth %K (fast), the Slow Stochastic Oscillator was developed. The Slow Stochastic Oscillator is plotted in the lower box: the thick black line represents %K (slow) and the thin red line represents %D (slow). To find %K (slow) in the Slow Stochastic Oscillator, a 3-day SMA was applied to %K (fast). This 3-day SMA slowed (or smoothed) the data to form a slower version of %K (fast). A close examination would reveal that %D (Fast), the thin red line in the Fast Stochastic Oscillator, is identical to %K (Slow), the thick black line in the Slow Stochastic Oscillator. To form the trigger line, or %D (slow) in the Slow Stochastic Oscillator, a 3-day SMA was applied to %K (Slow). The Full Stochastic Oscillator takes three parameters. Just as in the Fast and Slow versions, the first parameter is the number of periods used to create the initial %K line and the last parameter is the number of periods used to create the %D (full) signal line. What's new is the additional parameter, the one in the middle. It is a "smoothing factor" for the initial %K line. The %K (full) line that gets plotted is a n-period SMA of the initial %K line (where n is equal to the middle parameter). The Full Stochastic Oscillator is more advanced and more flexible than it's Fast and Slow cousins. You can even use it to duplicate the other versions. For example, a (14, 3) Fast Stochastic is equivalent to a (14, 1, 3) Full Stochastic and a (12, 2) Slow Stochastic is equal to a (12, 3, 2) Full Stochastic. %K and %D Recap ● ● ● ● ● ●

%K (fast) = %K formula presented above using x periods %D (fast) = y-day SMA of %K (fast) %K (slow) = 3-day SMA of %K (fast) %D (slow) = y-day SMA of %K (slow) %K (full) = y-day SMA of %K (fast) %D (full) = z-day SMA of %K (full)

where x is the first parameter, y is the second parameter and (in the case of Full stochastics), z is the third parameter. In the case of Fast and Slow Stochastics, x is typically 14 and y is usually set to 3.

Use

Readings below 20 are considered oversold and readings above 80 are considered http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_stochasticOscillator-print.html (4 of 7) [2/18/2003 5:28:28 AM]

StockCharts.com - Stochastic Oscillator

overbought. However, Lane did not believe that a reading above 80 was necessarily bearish or a reading below 20 bullish. A security can continue to rise after the Stochastic Oscillator has reached 80 and continue to fall after the Stochastic Oscillator has reached 20. Lane believed that some of the best signals occurred when the oscillator moved from overbought territory back below 80 and from oversold territory back above 20. Buy and sell signals can also be given when %K crosses above or below %D. However, crossover signals are quite frequent and can result in a lot of whipsaws. One of the most reliable signals is to wait for a divergence to develop from overbought or oversold levels. Once the oscillator reaches overbought levels, wait for a negative divergence to develop and then a cross below 80. This usually requires a double dip below 80 and the second dip results in the sell signal. For a buy signal, wait for a positive divergence to develop after the indicator moves below 20. This will usually require a trader to disregard the first break above 20. After the positive divergence forms, the second break above 20 confirms the divergence and a buy signal is given.

Example

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_stochasticOscillator-print.html (5 of 7) [2/18/2003 5:28:28 AM]

StockCharts.com - Stochastic Oscillator

In the IBM example above, it is clear that acting solely on overbought and oversold crossovers can generate false signals. Using crossovers of %D (slow) by %K (slow) can result in some good signals, but there are still whipsaws. By looking for divergences and overbought/oversold crossovers together, the 14-day Slow Stochastic Oscillator can produce fewer yet more reliable signals. The Slow Stochastic Oscillator produced 2 solid signals in IBM between Aug-99 and Mar-99. In Nov-99, a buy signal was given when the indicator formed a positive divergence and moved above 20 for the second time. Note http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_stochasticOscillator-print.html (6 of 7) [2/18/2003 5:28:28 AM]

StockCharts.com - Stochastic Oscillator

that the double top in Nov-Dec (gray circle) was not a negative divergence -- the stock continued higher after this formed. In Jan-00, a sell signal was given when a negative divergence formed and the indicator dipped below 80 for the second time.

SharpChart Application

In StockCharts.com's SharpCharts tool, the Slow Stochastic Oscillator uses %K (slow) and the Fast Stochastic Oscillator uses %K (fast). There are two options available for both fast or slow. The first box represents the number of periods used to calculate %K for each. The second box represents the number of periods used in the moving average to form %D. The defaults are 14 and 3. For the Slow Stochastic Oscillator, that would imply a 14-period %K (slow) with a 3-day SMA of %K (slow) to form %D (slow). The Full Stochastic uses three parameters: the period for %K (fast), the period for the SMA that smooths %K (fast), and the period of the SMA that forms %D (full). While the tool provides some excellent default values, I encourage you to test different variations to discover what fits with their particular investing style or what works with a particular security. For more, please see our Chart School article on how to use and interpret oscillators.

Written by Arthur Hill

Send us your Feedback!

©2002 StockCharts.com All Rights Reserved Terms of Use

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_stochasticOscillator-print.html (7 of 7) [2/18/2003 5:28:28 AM]

StockCharts.com - StochRSI

StochRSI

Overview

Developed by Tushard Chande and Stanley Kroll, StochRSI is an oscillator that measures the level of RSI relative to its range, over a set period of time. The indicator uses RSI as the foundation and applies to it the formula behind Stochastics. The result is an oscillator that fluctuates between 0 and 1. In their 1994 book, The New Technical Trader, Chande and Kroll explain that RSI sometimes trades between 80 and 20 for extended periods without reaching overbought and oversold levels. Traders looking to enter a stock based on an overbought or oversold reading in RSI might find themselves continuously on the sidelines. To increase the sensitivity and provide a method for identifying overbought and oversold levels in RSI, Chande and Kroll developed StochRSI. Developed by Welles Wilder, RSI is a momentum oscillator that compares the magnitude of gains to the magnitude of losses over a period of time. Developed by George Lane, Stochastics is a momentum oscillator that compares the closing level to the high/low range over a given period of time.

Formulas

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_stochRSI-print.html (1 of 5) [2/18/2003 5:28:40 AM]

StockCharts.com - StochRSI

From the formula above, it can be seen that StochRSI is the Stochastics formula applied to RSI; that is, it's an indicator of RSI. StochRSI measures the value of RSI relative to its high/low range over a set number of periods. When RSI records a new low for the period, StochRSI will be at 0. When RSI records a new high for the period, StochRSI will be at 100. A reading of .20 would mean that the current RSI was 20% above the lowest level of the period, or 80% below the highest level. A reading of .80 would mean that the current RSI was 80% above the lowest level of the period, or 20% below the highest level.

Signals

●

●

●

●

Overbought and Oversold Crossovers: If an uptrend has been identified in the underlying security, then a buy signal would be generated when StochRSI advances from oversold (below .20) to above .20. Conversely, if a downtrend has been identified, then a sell signal would be generated when StochRSI declines from overbought (above .80) to below .80. Centerline Crossovers: Some traders look for moves above or below .50 (the centerline) to confirm signals and reduce whipsaws. A move from oversold to above .50 could constitute a buy signal and would remain in place until a decline below .50. Conversely, a move from overbought to below .50 would could act as a sell signal that would remain in place until an advance back above .50. Positive and Negative Divergences: A positive divergence followed by a confirming advance above .20 could constitute a buy signal and a negative divergence followed by a decline below .80 could act as a sell signal. Failures: Chande and Kroll also note that moves back past the trigger lines would indicate a failed signal. An advance back above .80 would indicate a failed signal

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_stochRSI-print.html (2 of 5) [2/18/2003 5:28:40 AM]

StockCharts.com - StochRSI

●

and traders would be advised to close positions. Strong Trend: As with many oscillators, StochRSI can become overbought (or oversold) and remain overbought (or oversold) for an extended period. A move above .80 may imply overbought, but it can also indicate a strong up trend and remain above .80 for a prolonged period. Conversely, a quick move below .20 could indicate the beginning of a strong downtrend. Moves to 1 are considered very strong and moves to 0 very weak.

Example

(Click here to see a live example of StochRSI) http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_stochRSI-print.html (3 of 5) [2/18/2003 5:28:40 AM]

StockCharts.com - StochRSI

In the WCOM example above, the stock peaked in Jun-99 and was in a well-established downtrend. A series of lower lows and lower highs confirmed the primary trend as bearish. According to Chande and Kroll, these conditions would best suit StochRSI for identifying overbought levels from which to short the stock. Each time StochRSI advances above .80, an overbought situation would occur. When the indicator declined from its overbought level back below .80, a sell signal would have been given. From March to June, the indicator gave 4 sell signals, or one per month. The July sell signal was not recognized because there was a possible change in trend. As long as the series of lower highs and lower lows continued, the downtrend remained intact. A higher low in late June was followed by a higher high in July to call into question the strength and validity of the downtrend. Once the higher high arrived, the signals for StochRSI may have required adjustments to protect against whipsaws. Trying to buy the stock on advances from oversold levels back above .20 would have proved difficult. There were whipsaws in March and May that would have resulted in some bad trades. This choppy action around .20 could have also led to some premature exits from profitable short positions. When a stock is trending lower, it is sometimes prudent to raise the level in order to close short positions (or to generate buy signals). In this case, a trader could have required StochRSI to move from oversold to above .50 before closing short positions. This would have eliminated the March and May whipsaws. Conclusions It is important to remember that StochRSI is an indicator of an indicator. It is designed to predict extreme readings in RSI before the actual RSI reaches these extremities. As an indicator of an indicator, it is further removed from the actual price of the underlying security. Because it is actually predicting RSI, but being used to predict price changes in the underlying security, it will have greater sensitivity and be prone to false signals, especially if used incorrectly. As with other indicators, StochRSI should be used in conjunction with other indicators and aspects of technical analysis.

Written by Arthur Hill

Send us your Feedback!

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_stochRSI-print.html (4 of 5) [2/18/2003 5:28:40 AM]

StockCharts.com - StochRSI

©2002 StockCharts.com All Rights Reserved Terms of Use

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_stochRSI-print.html (5 of 5) [2/18/2003 5:28:40 AM]

StockCharts.com - TRIN

TRIN Richard Arms developed the TRIN, or Arms index, as a contrarian indicator to detect overbought and oversold levels in the market. Because of its calculation method, the TRIN has an inverse relationship with the market. Generally, a rising TRIN is bearish and a falling TRIN is bullish. Sometimes you will see the scale of the TRIN inverted to reflect this inverse relationship. The TRIN is the advance/decline ratio divided by the advance volume/decline volume ratio: ((Advancing issues/declining issues) / (advancing volume/declining volume)) Examples of TRIN calculations:

In the first example, the ratios were equal and the TRIN was 1, which indicates a standoff. Volume flowing into advancing stocks was virtually equal to volume flowing into declining stocks. In the second example, the up volume/down volume ratio did not keep up with the advance/decline ratio and the TRIN rose above 1. A TRIN above 1 indicates that the volume in declining stocks outpaced the volume in advancing stocks. In the final example the TRIN was below 1, indicating the volume in advancing stocks was healthy and outpaced the volume in declining stocks. NYSE http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_TRIN-print.html (1 of 3) [2/18/2003 5:28:50 AM]

StockCharts.com - TRIN

A number of TRIN interpretations have evolved over the years. Richard Arms, the originator, uses the TRIN to detect extreme conditions in the market. He considers the market to be overbought when the 10-day moving average of the TRIN declines below .8 and oversold when it moves above 1.2. Other interpretations seek to use the direction and absolute level of the TRIN to determine bullish and bearish scenarios. In the momentum driven markets, the TRIN can remain oversold or overbought for extended periods of time.

Written by Arthur Hill

Send us your Feedback!

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_TRIN-print.html (2 of 3) [2/18/2003 5:28:50 AM]

StockCharts.com - TRIN

©2002 StockCharts.com All Rights Reserved Terms of Use

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_TRIN-print.html (3 of 3) [2/18/2003 5:28:50 AM]

StockCharts.com - CBOE Volatility Index (VIX)

CBOE Volatility Index (VIX) (Click here to see a live example of the VIX) Introduced by the CBOE in 1993, VIX is a weighted measure of the implied volatility for 8 OEX put and call options. The 8 puts and calls are weighted according to time remaining and the degree to which they are in or out of the money. The result forms a composite hypothetical option that is at-the-money and has 30 days to expiration. (An at-the-money option means that the strike price and the security price are the same.) VIX represents the implied volatility for this hypothetical at-the-money OEX option.

OEX options are by far the most traded and most liquid index options on the CBOE. Because of their dominant activity, OEX options represent a good proxy for implied volatility of the market as a whole. As OEX trades, VIX is updated throughout the day and can be tracked as an intraday, daily, weekly or monthly indicator of implied volatility and market expectations. Typically, VIX (and by extension implied volatility) has an inverse relationship to the market. A chart of the VIX will usually be shown with the scale inverted to show the low readings at the top and high readings at the bottom. The value of VIX increases when the market declines and decreases when the market rises. It seems that volatility would be a two-way street. However, the stock market has a bullish bias. A rising stock market is viewed as less risky and a declining stock market more risky. The higher the http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_VIX-print.html (1 of 4) [2/18/2003 5:28:59 AM]

StockCharts.com - CBOE Volatility Index (VIX)

perceived risk is in stocks, the higher the implied volatility and the more expensive the associated options, especially puts. Hence, implied volatility is not about the size of the price swings, but rather the implied risk associated with the stock market. When the market declines, the demand for puts usually increases. Increased demand means higher put prices and higher implied volatilities. For contrarians, comparing VIX action with that of the market can yield good clues on future direction or duration of a move. The further VIX increases in value, the more panic there is in the market. The further VIX decreases in value, the more complacency there is in the market. As a measure of complacency and panic, VIX is often used as a contrarian indicator. Prolonged and/or extremely low VIX readings indicate a high degree of complacency and are generally regarded at bearish. Some contrarians view readings below 20 as excessively bearish. Conversely, prolonged and/or extremely high VIX readings indicate a high degree or anxiety or even panic among options traders and are regarded at bullish. High VIX readings usually occur after an extended or sharp decline and sentiment is still quite bearish. Some contrarians view readings above 30 as bullish. Conflicting signals between VIX and the market can yield sentiment clues for the short term, also. Overly bullish sentiment or complacency is regarded as bearish by contrarians. On the other hand, overly bearish sentiment or panic is regarded as bullish. If the market declines sharply and VIX remains unchanged or decreases in value (towards complacency), it could indicate that the decline has further to go. Contrarians might take the view that there is still not enough bearishness or panic in the market to warrant a bottom. If the market advances sharply and VIX increases in value (towards panic), it could indicate that the advance has further to go. Contrarians might take the view that there is not enough bullishness or complacency to warrant a top.

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_VIX-print.html (2 of 4) [2/18/2003 5:28:59 AM]

StockCharts.com - CBOE Volatility Index (VIX)

The chart above shows the inverse relationship between VIX and OEX. Generally, VIX decreases in value as OEX rises, and visa versa. A 10-day SMA was applied to both the VIX and OEX for smoothing. Over the last three years (Oct-97 to Sept-00), VIX produced roughly 7 extreme readings greater than 30 (light green) or less than 20 (light red). The four readings above 30 indicated excessive bearishness, panic or an extremely high implied volatility: Nov-97, Sept-98, Feb-99 and Apr-00 (green arrows). The three readings below 20 indicated excessive bullishness, complacency or low implied volatility (red arrows). Once the extreme readings were recorded, a confirmation signal was given when VIX returned above 20 or below 30 (vertical dotted line). Except for the first bearish signal in Mar-98 (black circle), most of the signals were pretty timely. Two of the bullish signals produced small double bottoms in the VIX that could have led to small http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_VIX-print.html (3 of 4) [2/18/2003 5:28:59 AM]

StockCharts.com - CBOE Volatility Index (VIX)

whipsaws, but the subsequent "second" signals proved quite profitable. As of this writing (13 September 2000), the VIX 10-day SMA has just risen above 20 and this could be considered the fourth signal of excessive bullishness or complacency among option traders. Note on Rex Takasugi's VIX chart: Rex inverts VIX by taking the reciprocal of the open, high, low and close. If VIX is 30, then 1/30 = .033. For more information on options, option pricing and volatility, see the following: ● ● ●

CBOE Website Trading Index Options by James B. Bittman Buying and Selling Volatility by Kevin Connolly

Written by Arthur Hill

Send us your Feedback!

©2002 StockCharts.com All Rights Reserved Terms of Use

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_VIX-print.html (4 of 4) [2/18/2003 5:28:59 AM]

StockCharts.com - Williams %R

Williams %R Developed by Larry Williams, Williams %R is a momentum indicator that works much like the Stochastic Oscillator. It is especially popular for measuring overbought and oversold levels. The scale ranges from 0 to -100 with readings from 0 to -20 considered overbought, and readings from -80 to -100 considered oversold. William %R, sometimes referred to as %R, shows the relationship of the close relative to the high-low range over a set period of time. The nearer the close is to the top of the range, the nearer to zero (higher) the indicator will be. The nearer the close is to the bottom of the range, the nearer to -100 (lower) the indicator will be. If the close equals the high of the high-low range, then the indicator will show 0 (the highest reading). If the close equals the low of the high-low range, then the result will be -100 (the lowest reading).

(Click here to see a live example of Williams %R) Typically, Williams %R is calculated using 14 periods and can be used on intraday, daily, weekly or monthly data. The timeframe and number of periods will likely vary according to desired sensitivity and the characteristics of the individual security. It is important to remember that overbought does not necessarily imply time to sell and oversold does not necessarily imply time to buy. A security can be in a downtrend, become oversold and remain oversold as the price continues to trend lower. Once a security becomes overbought or oversold, traders should wait for a signal that a price reversal has occurred. One method might be to wait for Williams %R to cross above or below -50 for confirmation. Price reversal confirmation can also be accomplished by using other indicators or aspects of technical analysis in conjunction with Williams %R. One method of using Williams %R might be to identify the underlying trend and then look for trading opportunities in the direction of the trend. In an uptrend, traders may look to oversold readings to establish long positions. In a downtrend, traders may look to overbought readings to establish short positions.

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_williamsR-print.html (1 of 3) [2/18/2003 5:29:09 AM]

StockCharts.com - Williams %R

The chart of Weyerhauser with a 14-day and 28-day Williams %R illustrates some key points: ● ●

●

●

14-day %R appears quite choppy and prone to false signals. 28-day %R smoothed the data series and the signals became less frequent and more reliable. When the 28-day %R moved to overbought or oversold levels, it typically remained there for an extended period and the stock continued its trend. Some good entry signals were given with the 28-day %R by waiting for a move above or below -50 for confirmation.

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_williamsR-print.html (2 of 3) [2/18/2003 5:29:09 AM]

StockCharts.com - Williams %R

Written by Arthur Hill

Send us your Feedback!

©2002 StockCharts.com All Rights Reserved Terms of Use

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_williamsR-print.html (3 of 3) [2/18/2003 5:29:09 AM]

StockCharts.com - ZigZag

ZigZag The ZigZag feature on SharpCharts is not an indicator per se, but rather a means to filter out random noise and compare relative price movements. The ZigZag can be set to acknowledge minimum price changes and ignore those that do not fit the criteria. The minimum price movements are set in percentage terms and can be based on either the close or high/low range. A ZigZag set at 10% with OHCL bars would yield a line that only reverses after a change from high to low of 10% or greater. All movements less than 10% would be ignored. If a stock traded from a low of 100 to a high of 109, the ZigZag would not draw a line because the move was less than 10%. If the stock advanced from a low of 100 to a high of 110, then the ZigZag would draw a line from 100 to 110. If the stock continued on to a high of 112, this line would be extended to 112 (100 to 112). The ZigZag would not reverse until the stock declined 10% or more from its high. From a high of 112, a stock would have to decline 11.2 points (or to a low of 100.8) for the ZigZag to reverse and display another line. Uses of ZigZag Filter: Volatility and daily price fluctuations can produce erratic movements or noise. The ZigZag can be used to filter this noise. If price movements smaller than 5% are deemed insignificant, then the ZigZag can be set at 5% and all movements less than 5% will be ignored. Elliott Wave: The ZigZag can be used to identify waves for Elliott Wave counts. (Note: The object of this article is not Elliott Wave Theory, but simply to illustrate methods of using the ZigZag.)

Elliott Wave

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_Zigzag-print.html (1 of 8) [2/18/2003 5:29:21 AM]

StockCharts.com - ZigZag

(Chart for HWP) The HWP example set the ZigZag at 15%. All moves 15% or greater were drawn and those less that 15% ignored. A large advance began in Oct-99 and formed a 5-wave structure that lasted until mid 2000. Within this larger structure, other smaller waver counts can also be deciphered. Retracements: The ZigZag can be used to measure retracements. After an advance, it is common for a security to retrace a portion of its advance with a correction. After a decline, it is common for a security to retrace part of its decline with a reaction rally. According to Dow Theory, 1/3, 1/2 and 2/3 retracements are most likely. Based on Fibonacci numbers, 38.2% or 61.8% retracement levels are deemed significant. Retracements

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_Zigzag-print.html (2 of 8) [2/18/2003 5:29:21 AM]

StockCharts.com - ZigZag

(Chart for HAL) During the advance from 34 to 55, HAL corrected twice (waves 2 and 4) and fulfilled two Fibonacci retracement targets: .618 and .786. Perhaps the most important Fibonacci number is .618, which is the golden mean. The square root of .618 is .786 (78.6%), another Fibonacci number used frequently by Scott Carney. In Mar-00, HAL retraced 79.8% of its wave 1 advance (red oval). From the Mar-00 low, the stock advanced 1.70 times its previous decline to form wave 3, which is close to a Fibonacci 1.618. The correction on wave 4 retraced 67.6% of the wave 3 advance. While 67.6% and 79.8% are not exact Fibonacci retracements, they are close enough to 61.8% and 78.6% to warrant attention. Projections: The ZigZag can be used to measure primary price movements. As opposed to a correction or reaction rally, a primary price movement is in the direction of the underlying trend. Instead of retracing a portion of the previous move, primary moves extend past the previous reaction high or low. Many analysts that use Elliott Wave and Fibonacci sequences project the length of an advance or decline by multiplying a ratio to the previous retracement. If the previous decline (correction) was 50 points and a Fibonacci specialist was looking for new highs on the subsequent advance, the projection might be 1.618 times the previous move, or 81 points (50 x 1.618 = 81).

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_Zigzag-print.html (3 of 8) [2/18/2003 5:29:21 AM]

StockCharts.com - ZigZag

The 81 points would be added to the beginning of the advance for a price target. SharpCharts Application

There are two ZigZag options on SharpCharts: the ZigZag (Basic) and the ZigZag w/Retracements. Both plot the same line, but the ZigZag w/Retracments adds labels and dotted lines for retracement ratios. The ZigZag (Basic) plots a line based on a minimum percentage change in price. The price change can be based on closing levels or the high/low range. To calculate the ZigZag based on closing prices only, select "Line (NAV)" in Price Style box under the heading Price Attributes. To calculate the ZigZag based on the high/low range, select OHCL Bars, HLC Bars or Candlesticks as the price style. ZigZag (Basic)

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_Zigzag-print.html (4 of 8) [2/18/2003 5:29:21 AM]

StockCharts.com - ZigZag

(Current Chart for IBM) The percentage price change for the ZigZag can changed with the first box to the right. The default setting is 5%. In the example, the indicator was set at 12, or 12 percent. All price movements greater than or equal to 12% will produce a ZigZag line. All price movements less than 12% will be ignored. The ZigZag is plotted as a thick line on top of the price plot.

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_Zigzag-print.html (5 of 8) [2/18/2003 5:29:21 AM]

StockCharts.com - ZigZag

ZigZag w/Retracements

(Current Chart for IBM) The ZigZag w/Retracements includes ratios of adjacent price movements. For the IBM example, the ZigZag w/Retracements was set at 12% to filter out all price movements less than 12%. Three pairs of price movements were compared from the Jun-00 to Nov00. Dotted lines connect the relevant highs or relevant lows and the ratio is labeled in the middle of the dotted line. The first ratio is 1.566, representing an advance that was 156.6% of the previous decline. The formula is calculated in three steps: ● ● ●

First Price Move - Decline: 122.31 - 100 = 22.31 Second Price Move - Advance: 134.94 - 100 = 34.94 Advance/Decline Ratio: 34.94/22.31 = 1.566

Calculations for the other two ratios (1.374 and .309) are shown on the corresponding chart. ZigZag Warning The ZigZag has zero predictive power and draws lines base on hindsight. Any predictive power will come from applications such as Elliott Wave or Fibonacci retracements and http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_Zigzag-print.html (6 of 8) [2/18/2003 5:29:21 AM]

StockCharts.com - ZigZag

projections. Warning

The final line for the ZigZag is subject to change. On the IBM example above, the current ZigZag high is 104.38. Because of the recent decline, the ZigZag continued down from 104.38. However, the current decline is well short of the 12% minimum. Should the current decline fail to exceed 12% and should IBM advance above 104.38, then the line from 86.94 would be extended to the new high and the ratio (.363) would change. The red line in the example above provides an idea of what would happen should IBM turn up from current levels and move to 110. The green lines extending from the October low would be replaced by a line extending straight up to 110.

Written by Arthur Hill

Send us your Feedback!

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_Zigzag-print.html (7 of 8) [2/18/2003 5:29:21 AM]

StockCharts.com - ZigZag

©2002 StockCharts.com All Rights Reserved Terms of Use

http://www.stockcharts.com/education/What/IndicatorAnalysis/indic_Zigzag-print.html (8 of 8) [2/18/2003 5:29:21 AM]

Market Analysis -- Chart School

SharpChart: Symbol Catalog

You are logged out Log in

You are here: Chart School > What is TA? > Market Analysis

Search the Site:

Advanced Search

Market Analysis

Chart School Technical Analysis Overview Chart Analysis Indicator Analysis Market Analysis Trading Strategies Analysis Tools SharpCharts PerfCharts Point & Figure Charts Stock Scans Market Carpet Additional Resources Bookstore Glossary Newsletter Archives Mailbag Articles Using StockCharts.com Recommended Sites

The Dow Theory-

The Dow theory has been around for almost 100 years, yet even in today's volatile and technologydriven markets, the basic components of Dow theory still remain valid. Part 1

Elliot Wave Theory-

Our Bookstore

Part 3

R. N. Elliott believed markets had well-defined waves that could be used to predict market direction. Hence the Elliott Wave Theory, which states that stock prices are governed by cycles founded upon the Fibonacci series.

Join Now!

Books on: Our Favorites Technical Analysis Books by John Murphy P&F Charting General Investing

Part 2

Financial Ad Trader

http://www.stockcharts.com/education/What/MarketAnalysis/index.html (1 of 2) [2/18/2003 5:29:27 AM]

Market Analysis -- Chart School

Join Now! | Newsletter | FAQ | Glossary | Terms of Use Home | Free Charts | Chart School | Members | Support Data provided by: Unless otherwise indicated, all data is delayed by 20 minutes ©1999-2003 StockCharts.com All Rights Reserved

http://www.stockcharts.com/education/What/MarketAnalysis/index.html (2 of 2) [2/18/2003 5:29:27 AM]

StockCharts.com - Dow Theory Part 1

Dow Theory Part 1

Introduction

The Dow theory has been around for almost 100 years, yet even in today's volatile and technology-driven markets, the basic components of Dow theory still remain valid. Developed by Charles Dow, refined by William Hamilton and articulated by Robert Rhea, the Dow theory addresses not only technical analysis and price action, but also market philosophy. Many of the ideas and comments put forth by Dow and Hamilton became axioms of Wall Street. While there are those who may think that it is different this time, a read through The Dow Theory will attest that the stock market behaves the same today as it did almost 100 years ago. The Dow theory presented below has been taken from Robert Rhea's book, The Dow Theory. Although Dow theory is attributed to Charles Dow, it is William Hamilton's writings that serve as the corner stone for this book and the development of the theory. Also, it should be noted that most of the theory was developed with the Dow Jones Rail and Industrial averages in mind. Even though many concepts can be applied to individual stocks, please keep in mind that these are broad concepts and best applied to stocks as a group or index. When possibly, we have also attempted to link some of the realities of today's market with the Dow theory as explained by Dow, Hamilton and Rhea. Background

Charles Dow developed the Dow theory from his analysis of market price action in the late 19th century. Until his death in 1902, Dow was part owner as well as editor of The Wall Street Journal. Although he never wrote a book on the subject, he did write some editorials that reflected his views on speculation and the role of the rail and industrial averages. Even though Charles Dow is credited with developing the Dow theory, it was S.A. Nelson and William Hamilton who later refined the theory into what it is today. Nelson wrote The ABC of Stock Speculation and was the first to actually use the term "Dow theory." Hamilton further refined the theory through a series of articles in The Wall Street Journal from 1902 to 1929. Hamilton also wrote The Stock Market Barometer in 1922, which sought to explain the theory in detail.

http://www.stockcharts.com/education/What/MarketAnalysis/dowtheory1-print.html (1 of 5) [2/18/2003 5:29:36 AM]

StockCharts.com - Dow Theory Part 1

In 1932, Robert Rhea further refined the analysis of Dow and Hamilton in The Dow Theory. Rhea read, studied and deciphered some 252 editorials through which Dow (1900-1902) and Hamilton (1902-1929) conveyed their thoughts on the market. Rhea also referred to Hamilton's The Stock Market Barometer. The Dow Theory presents the Dow theory as a set of assumptions and theorems. Assumptions

Before one can begin to accept the Dow theory, there are a number of assumptions that must be accepted. Rhea stated that for the successful application of the Dow theory, these assumptions must be accepted without reservation. Manipulation The first assumption is: The manipulation of the primary trend is not possible. When large amounts of money are at stake, the temptation to manipulate is bound to be present. Hamilton did not argue against the possibility that speculators, specialists or anyone else involved in the markets could manipulate the prices. He qualified his assumption by asserting that it was not possible to manipulate the primary trend. Intraday, day-to-day and possibly even secondary movements could be prone to manipulation. These short movements, from a few hours to a few weeks, could be subject to manipulation by large institutions, speculators, breaking news or rumors. Today, Hamilton would likely add message boards and day-traders to this list. Hamilton went on to say that individual shares could be manipulated. Examples of manipulation usually end the same way: the security runs up and then falls back and continues the primary trend. Examples include: ●

●

●

PairGain Technology rose sharply due to a hoax posted on a fake Bloomberg site. However, once the hoax was revealed, the stock immediately fell back and returned to its primary trend. Books-A-Million rose from 3 to 47 after announcing an improved web site. Three weeks later, the stock settled around 10 and drifted lower from there. In 1979/80, there was an attempt to manipulate the price of silver by the Hunt brothers. Silver skyrocketed to over 50$ per ounce, only to come back down to earth and resume its long bear market after the plot to corner the market was unveiled.

While these shares were manipulated over the short term, the long-term trends prevailed after about a month. Hamilton also pointed out that even if individual shares were being manipulated, it would be virtually impossible to manipulate the market as a whole. The market was simply too big for this to occur. Averages Discount Everything http://www.stockcharts.com/education/What/MarketAnalysis/dowtheory1-print.html (2 of 5) [2/18/2003 5:29:36 AM]

StockCharts.com - Dow Theory Part 1

The market reflects all available information. Everything there is to know is already reflected in the markets through the price. Prices represent the sum total of all the hopes, fears and expectations of all participants. Interest rate movements, earnings expectations, revenue projections, presidential elections, product initiatives and all else are already priced into the market. The unexpected will occur, but usually this will affect the short-term trend. The primary trend will remain unaffected. The chart below of Coca-Cola is a recent example of the primary trend remaining intact. The downtrend for Coca-Cola began with the sharp fall from above 90. The stock rallied with the market in October and November 1998, but by December started to decline again. According to Dow Theory, the October/November rally would be called a secondary move (against the primary trend). It is likely that the stock was caught up in the general market advance at the time. However, when the major indices were hitting new highs in December, Coca-Cola was starting to flounder and resume its primary trend.

Hamilton noted that sometimes the market would react negatively to good news. For Hamilton, the reasoning was simple: the market looks ahead. By the time the news hits the street, it is already reflected in the price. This explains the old Wall Street axiom, "buy the rumor, sell the news". As the rumor begins to filter down, buyers step in and bid the price up. By the time the news hits, the price has been bid up to fully reflect the news. Yahoo! and the run up to earnings is a classic example. For the past three quarters, Yahoo! has been bid up leading right up to the earnings report. Even though earnings have exceeded expectations each time, the stock has fallen by about 20%.

http://www.stockcharts.com/education/What/MarketAnalysis/dowtheory1-print.html (3 of 5) [2/18/2003 5:29:36 AM]

StockCharts.com - Dow Theory Part 1

Theory Not Perfect Hamilton and Dow readily admit that the Dow theory is not a sure-fire means of beating the market. It is looked upon as a set of guidelines and principles to assist investors and traders with their own study of the market. The Dow theory provides a mechanism for investors to use that will help remove some of the emotion. Hamilton warns that investors should not be influenced by their own wishes. When analyzing the market, make sure you are objective and see what is there, not what you want to see. If an investor is long, he or she may want to see only the bullish signs and ignore any bearish signals. Conversely, if an investor is out of the market or short, he or she may be apt to focus on the negative aspects of the price action and ignore any bullish developments. Dow Theory provides a mechanism to help make decisions less ambiguous. The methods for identifying the primary trend are clear-cut and not open to interpretation. Even though the theory is not meant for short-term trading, it can still add value for traders. No matter what your time frame, it always helps to be able to identify the primary trend. According to Hamilton (writing in the early part of the 20th century), those who successfully applied the Dow theory rarely traded more than four or five times a year. Remember that intraday, day-to-day and possibly even secondary movements can be prone to manipulation, but the primary trend is immune from manipulation. Hamilton and Dow sought a means to filter out the noise associated with daily fluctuations. They were not worried about a couple of points, or getting the exact top or bottom. Their main concern was catching the large moves. Both Hamilton and Dow recommended close study of the markets on a daily basis, but they also sought to minimize the effects of random movements and concentrate on the primary trend. It is easy to get caught up in the madness of the moment and forget the primary trend. After the October low, the primary trend for Coca-Cola remained bearish. Even though there were some sharp advances, the stock never forged a higher high.

http://www.stockcharts.com/education/What/MarketAnalysis/dowtheory1-print.html (4 of 5) [2/18/2003 5:29:36 AM]

StockCharts.com - Dow Theory Part 1

End of Part 1 In Part 2 we talk about the different market movements (daily fluctuations, secondary and primary) and the three phases of bull and bear markets.

Written by Arthur Hill

Send us your Feedback!

©2002 StockCharts.com All Rights Reserved Terms of Use

http://www.stockcharts.com/education/What/MarketAnalysis/dowtheory1-print.html (5 of 5) [2/18/2003 5:29:36 AM]

StockCharts.com - Dow Theory Part 2

Dow Theory Part 2

Market Movements

Dow and Hamilton identified three types of price movements for the Dow Jones Industrial and Rail averages: primary movements, secondary movements and daily fluctuations. Primary moves last from a few months to many years and represent the broad underlying trend of the market. Secondary (or reaction) movements last from a few weeks to a few months and move counter to the primary trend. Daily fluctuations can move with or against the primary trend and last from a few hours to a few days, but usually not more than a week. Primary Movements Primary movements represent the broad underlying trend of the market and can last from a few months to many years. These movements are typically referred to as bull and bear markets. Once the primary trend has been identified, it will remain in effect until proven otherwise. (We will address the methods for identifying the primary trend in Part 3 of this Dow Theory article.) Hamilton believed that the length and the duration of the trend were largely indeterminable. Hamilton did study the averages and came up with some general guidelines for length and duration, but warned against attempting to apply these as rules for forecasting. Many traders and investors get hung up on price and time targets. The reality of the situation is that nobody knows where and when the primary trend will end. The objective of Dow theory is to utilize what we do know, not to haphazardly guess about what we don't know. Through a set of guidelines, Dow theory enables investors to identify the primary trend and invest accordingly. Trying to predict the length and the duration of the trend is an exercise in futility. Hamilton and Dow were mainly interested in catching the big moves of the primary trend. Success, according to Hamilton and Dow, is measured by the ability to identify the primary trend and stay with it. Secondary Movements Secondary movements run counter to the primary trend and are reactionary in nature. In a bull market a secondary move is considered a correction. In a bear market, secondary moves are sometimes called reaction rallies. In part one of the Dow theory, a chart of Coca-Cola is used to illustrate reaction rallies (or secondary movements) within the confines of a primary bear trend. Below is a chart illustrating a correction within the confines of a primary bull trend.

http://www.stockcharts.com/education/What/MarketAnalysis/dowtheory2-print.html (1 of 7) [2/18/2003 5:29:46 AM]

StockCharts.com - Dow Theory Part 2

In Sept-96, the DJIA recorded a new high, thereby establishing the primary trend as bullish. From trough to peak, the primary advance rose 1988 points. During the advance from Sept-96 to Mar-97, the DJIA never declined for more than two consecutive weeks. By the end of March, after three consecutive weeks of decline, it became apparent that this move was not in the category of daily fluctuations and could be considered a secondary move. Hamilton noted some characteristics that were common to many secondary moves in both bull and bear markets. These characteristics should not be construed as rules, but rather as loose guidelines to be used in conjunction with other analysis techniques. The first three characteristics have been applied to the example above. 1. Based on historical observation, Hamilton estimated that secondary movements retrace 1/3 to 2/3 of the primary move, with 50% being the typical amount. In actuality, the secondary move in early 1997 retraced about 42% of the primary move. (7158 - 5170 = 1988; 7158 - 6316 = 842, 842/1988 = 42.35%). 2. Hamilton also noted that secondary moves tend to be faster and sharper than the preceding primary move. Just with a visual comparison, we can see that the secondary move was sharper that the preceding primary advance. The primary move advanced 38% (1988/5178 = 38%) and lasted from Jul-96 to Mar-97, about 8 months. The secondary move witnessed a correction of 11.7% (842/7158 http://www.stockcharts.com/education/What/MarketAnalysis/dowtheory2-print.html (2 of 7) [2/18/2003 5:29:46 AM]

StockCharts.com - Dow Theory Part 2

= 11.7%) and lasted a mere five weeks. 3. At the end of the secondary move, there is usually a dull period just before the turnaround. Little price movement, a decline in volume, or a combination of the two can mark this dullness. Below is a daily chart focusing on the Apr-97 low for the secondary move outlined above.

April 7 through 10 marked the dull point (red line on volume). There was little price movement and volume was the lowest since the decline began. The DJIA then gapped down on an increase in volume. After the down gap, there was a reversal day and then the DJIA proceeded with a gap up and breakout to a reaction high on increasing volume (green line on volume). The new reaction high combined with the increase in volume indicated that the secondary move was over and the primary trend had resumed. 4. Lows are sometimes accompanied by a high-volume washout day. The September/October lows in 1998 were accompanied by record volume levels. At the time, the low on Sept-1 witnessed the highest volume ever recorded and the Oct-8 low recorded the second highest volume ever. Although these high-volume lows were not a signal in and of themselves, they helped form a pattern that preceded a historical advance. This advance took the DJIA from below 8000 to http://www.stockcharts.com/education/What/MarketAnalysis/dowtheory2-print.html (3 of 7) [2/18/2003 5:29:46 AM]

StockCharts.com - Dow Theory Part 2

over 11000 in less than one year. Further confirmation of a change in trend came in the form of a new reaction high with high volume on Oct-15.

Dow Theory Note: There is still debate as to whether the crash of 1998 was a bear market or merely a secondary move within the confines of a larger bull market. In hindsight, it would appear to be a secondary move. Even though the DJIA recorded a lower low on August 4 and had lost just over 20% by September 4, the two-month time frame makes it difficult to justify as a bear market. Hamilton characterized secondary moves as a necessary phenomenon to combat excessive speculation. Corrections and counter moves kept speculators in check and added a healthy dose of guesswork to market movements. Because of their complexity and deceptive nature, secondary movements require extra careful study and analysis. Investors often mistake a secondary move for the beginning of a new primary trend. How far does a secondary move have to go before the primary trend is affected? This issue will be addressed in Part 3 of this article, when we analyze the various signals based on Dow theory. Daily Fluctuations Daily fluctuations, while important when viewed as a group, can be dangerous and unreliable individually. Due to the randomness of the movements from day to day, the forecasting value of daily fluctuations is limited at best. At worst, too much emphasis on daily fluctuation will lead to forecasting errors and possibly losses. Getting too caught up in the movement of one or two days can lead to hasty decisions that are based on http://www.stockcharts.com/education/What/MarketAnalysis/dowtheory2-print.html (4 of 7) [2/18/2003 5:29:46 AM]

StockCharts.com - Dow Theory Part 2

emotion. It is vitally important to keep the whole picture in mind when analyzing daily price movements. Think of the pieces of a puzzle. Individually, a few pieces are meaningless, yet at the same time they are essential to complete the picture. Daily price movements are important, but only when grouped with other days to form a pattern for analysis. Hamilton did not disregard daily fluctuations, quite to the contrary. The study of daily price action can add valuable insight, but only when taken in context of the larger picture. There is little structure in one, two or even three days' worth of price action. However, when a series of days is combined, a structure will start to emerge and analysis becomes better grounded. The Three Stages of Primary Bull Markets and Primary Bear Markets

Hamilton identified three stages to both primary bull markets and primary bear markets. These stages relate as much to the psychological state of the market as to the movement of prices. A primary bull market is defined as a long sustained advance marked by improving business conditions that elicit increased speculation and demand for stocks. A primary bear market is defined as a long sustained decline marked by deteriorating business conditions and subsequent decrease in demand for stocks. In both primary bull markets and primary bear markets, there will be secondary movements that run counter to the major trend. Primary Bull Market - Stage 1 - Accumulation Hamilton noted that the first stage of a bull market was largely indistinguishable from the last reaction rally of a bear market. Pessimism, which was excessive at the end of the bear market, still reigns at the beginning of a bull market. It is a period when the public is out of stocks, the news from corporate America is bad and valuations are usually at historical lows. However, it is at this stage that the so-called "smart money" begins to accumulate stocks. This is the stage of the market when those with patience see value in owning stocks for the long haul. Stocks are cheap, but nobody seems to want them. This is the stage where Warren Buffet stated in the summer of 1974 that now was the time to buy stocks and become rich. Everyone else thought he was crazy. In the first stage of a bull market, stocks begin to find a bottom and quietly firm up. When the market starts to rise, there is widespread disbelief that a bull market has begun. After the first leg peaks and starts to head back down, the bears come out proclaiming that the bear market is not over. It is at this stage that careful analysis is warranted to determine if the decline is a secondary movement (a correction of the first leg up). If it is a secondary move, then the low forms above the previous low, a quiet period will ensue as the market firms and then an advance will begin. When the previous peak is surpassed, the beginning of the second leg and a primary bull will be confirmed. Primary Bull Market - Stage 2 - Big Move The second stage of a primary bull market is usually the longest, and sees the largest advance in prices. It is a period marked by improving business conditions and increased http://www.stockcharts.com/education/What/MarketAnalysis/dowtheory2-print.html (5 of 7) [2/18/2003 5:29:46 AM]

StockCharts.com - Dow Theory Part 2

valuations in stocks. Earnings begin to rise again and confidence starts to mend. This is considered the easiest stage to make money as participation is broad and the trend followers begin to participate. Primary Bull Market - Stage 3 - Excess The third stage of a primary bull market is marked by excessive speculation and the appearance of inflationary pressures. (Dow formed these theorems about 100 years ago, but this scenario is certainly familiar.) During the third and final stage, the public is fully involved in the market, valuations are excessive and confidence is extraordinarily high. This is the mirror image to the first stage of the bull market. A Wall Street axiom: When the taxi cab drivers begin to offer tips, the top cannot be far off. Primary Bear Market - Stage 1 - Distribution Just as accumulation is the hallmark of the first stage of a primary bull market, distribution marks the beginning of a bear market. As the "smart money" begins to realize that business conditions are not quite as good as once thought, they start to sell stocks. The public is still involved in the market at this stage and become willing buyers. There is little in the headlines to indicate a bear market is at hand and general business conditions remain good. However, stocks begin to lose a bit of their luster and the decline begins to take hold. While the market declines, there is little belief that a bear market has started and most forecasters remain bullish. After a moderate decline, there is a reaction rally (secondary move) that retraces a portion of the decline. Hamilton noted that reaction rallies during bear markets were quite swift and sharp. As with his analysis of secondary moves in general, Hamilton noted that a large percentage of the losses would be recouped in a matter of days or perhaps weeks. This quick and sudden movement would invigorate the bulls to proclaim the bull market alive and well. However, the reaction high of the secondary move would form and be lower than the previous high. After making a lower high, a break below the previous low would confirm that this was the second stage of a bear market. Primary Bear Market - Stage 2 - Big Move As with the primary bull market, stage two of a primary bear market provides the largest move. This is when the trend has been identified as down and business conditions begin to deteriorate. Earnings estimates are reduced, shortfalls occur, profit margins shrink and revenues fall. As business conditions worsen, the sell-off continues. Primary Bear Market - Stage 3 - Despair At the top of a primary bull market, hope springs eternal and excess is the order of the day. By the final stage of a bear market, all hope is lost and stocks are frowned upon. Valuations are low, but the selling continues as participants seek to sell no matter what. The news from corporate America is bad, the economic outlook bleak and not a buyer is to be found. The market will continue to decline until all the bad news is fully priced into stocks. Once stocks fully reflect the worst possible outcome, the cycle begins again.

http://www.stockcharts.com/education/What/MarketAnalysis/dowtheory2-print.html (6 of 7) [2/18/2003 5:29:46 AM]

StockCharts.com - Dow Theory Part 2

In part 3, we address Dow theory signals and talk about how to identify a change in the primary trend, why the averages must confirm, and how volume comes into play. Also, we address common criticisms of Dow theory and draw a few of our own conclusions.

Written by Arthur Hill

Send us your Feedback!

©2002 StockCharts.com All Rights Reserved Terms of Use

http://www.stockcharts.com/education/What/MarketAnalysis/dowtheory2-print.html (7 of 7) [2/18/2003 5:29:46 AM]

StockCharts.com - Dow Theory Part 3

Dow Theory Part 3

Signals

Through the writings of Dow and Hamilton, Rhea identified 4 separate theorems that addressed trend identification, buy and sell signals, volume, and trading ranges. The first two were deemed the most important and serve to identify the primary trend as bullish or bearish. The second two theorems, dealing with volume and trading ranges, were not considered instrumental in primary trend identification by Hamilton. Volume was looked upon as a confirming statistic and trading ranges were thought to identify periods of accumulation and distribution. Identification of the Trend

The first step in identifying the primary trend is to identify the individual trend of the Dow Jones Industrial Average (DJIA), and Dow Jones Transportation Average (DJTA), individually. Hamilton used peak and trough analysis in order to ascertain the identity of the trend. An uptrend is defined by prices that form a series of rising peaks and rising troughs (higher highs and higher lows). In contrast, a downtrend is defined by prices that form a series of declining peaks and declining troughs (lower highs and lower lows). Once the trend has been identified, it is assumed valid until proven otherwise. A downtrend is considered valid until a higher low forms and the ensuing advance off of the higher low surpasses the previous reaction high. Below is a chart of the Dow Jones Transportation Average in 1992. Even though Hamilton and Dow did not make specific references to trendlines, a line has been drawn to emphasize the downward trajectory of the trend. Since the peak in February, a series of lower lows and lower highs formed to make a downtrend. There was a secondary rally in April and May (green circle), but the March high was not surpassed.

http://www.stockcharts.com/education/What/MarketAnalysis/dowtheory3-print.html (1 of 10) [2/18/2003 5:29:58 AM]

StockCharts.com - Dow Theory Part 3

The DJTA continued down until the high volume washout day (red arrow). As discussed in part 2 of this article, high volume days signal that a possible change is looming. Alone, a high volume washout day is not a buy signal, but rather an indication to monitor price action a little closer. After this high volume day, the DJTA dipped again and then moved above 1250, creating a higher low (green arrow). Even after the higher low is in place, it is still too early to call for a change in trend. The change of trend is not confirmed until the previous reaction high is surpassed (blue arrow). Conversely, an uptrend is considered in place until a lower low forms and the ensuing decline exceeds the previous low. Below is a line chart of the closing prices for the DJIA. An uptrend began with the Oct-98 lows and the DJIA formed a series of higher highs and higher lows over the next 11 months. Twice, in Dec-98 (red circle) and Jun-99 (blue arrows), the validity of the uptrend came into question, but the uptrend prevailed until late September. (The Dec-98 price action is addressed below.) There were lower highs in Jun-99, but there were never any lower lows to confirm these lower highs and support held. Any bears that jumped the gun in June were made to sit through two more all-time highs in July and August. The change in trend occurred on September 23 when the June lows were violated. Some traders may have concluded that the trend

http://www.stockcharts.com/education/What/MarketAnalysis/dowtheory3-print.html (2 of 10) [2/18/2003 5:29:58 AM]

StockCharts.com - Dow Theory Part 3

changed when the late August lows were violated. This may indeed be the case, but it is worth noting that the June lows represented a more convincing support area. Keep in mind that the Dow theory is not a science and Hamilton points this out numerous times. The Dow theory is meant to offer insights and guidelines from which to begin careful study of the market movements and price action. DJIA 1998/1999

Looking at the line chart above (DJIA 1998/1999 daily close semi-log scale), it may be difficult to distinguish between a valid change in trend and a simple correction. For instance: Was a change in trend warranted when the December low penetrated the November low? (red circle) After the November peak, a lower high formed in December and then the November reaction low was broken. In order to eliminate false signals, Hamilton suggested excluding moves of less than 3%. This was not meant to be a hard and fast rule, but the idea is worth noting. With the increased volatility of today's markets comes the need to smooth the daily fluctuations and avoid false readings. Hamilton and Dow were interested in catching the big moves and would have been apt to use weekly charts to establish reaction highs and lows. However, in today's fast moving markets, weekly charts may not portray the detail that investors need. One possible solution is to apply a short moving average to the price plot. Although not mentioned by Hamilton and Dow, a 5-day moving average could be applied to smooth the price series and still allow for detail. The chart below (DJIA 1998/1999 daily close 5EMA) uses a 5-day exponential moving average to smooth the price plot. Notice that the November reaction low now appears quite immaterial. Also, the September reaction

http://www.stockcharts.com/education/What/MarketAnalysis/dowtheory3-print.html (3 of 10) [2/18/2003 5:29:58 AM]

StockCharts.com - Dow Theory Part 3

high (red arrow) still shows up. DJIA 1998/1999

Averages Must Confirm

When the Dow theory was being developed at the turn of the century, the railroads were a vital link in the economy. Hamilton argued that many times activity would begin in the Rail Average before the Industrial Average. He attributed this to the fact that before economic activity began, raw materials would have to be moved from the suppliers to manufacturers. Before General Motors could increase production, more steel would need to be transported. Therefore, an increase in activity among the rail stocks would foreshadow an increase in business activity for the industrial stocks. Why the Rails? There is no doubt that today's economy is much different and the makeup of the DJTA has changed to favor the airlines. However, there is still some credibility in using the DJTA to confirm movements in the DJIA. Transport stocks are much more dependent on the economic environment than the average stock and will likely foreshadow economic growth. ●

●

●

The airline business is cyclical and revenues are highly susceptible to economic changes. Airline companies typically carry above average levels of debt and will be more vulnerable to changes in interest rates. Energy and Labor costs form a large portion of expenses.

http://www.stockcharts.com/education/What/MarketAnalysis/dowtheory3-print.html (4 of 10) [2/18/2003 5:29:58 AM]

StockCharts.com - Dow Theory Part 3

To reflect the added risks above, airline stocks have traditionally sold significantly below market multiples. If the PE for the S&P 500 is 28, the average airline might sell for only 8-10 times earnings. Even though we are possibly entering into a "new economy," the majority of businesses will somehow be affected by changes in economic activity, interest rates, energy costs and labor costs. Airline companies, bearing the burden of all of the above, are still likely to act as a leading indicator of the general economic environment. However, one caveat must be added as well. Possibly the greatest fear of the airlines is that people will stop flying in airplanes. Business travel accounts for a large portion of airline revenues, especially the high margin revenues. With the development of the Internet and networking, the need for business travel could be greatly reduced in the future. Federal Express has already experienced a slowdown in the quantity of business documents being shipped. This could ultimately spill over into the business of the airlines. How Averages Confirm Hamilton and Dow stressed that for a primary trend buy or sell signal to be valid, both the Industrial Average and the Rail Average must confirm each other. If one average records a new high or new low, then the other must soon follow for a Dow theory signal to be considered valid.

http://www.stockcharts.com/education/What/MarketAnalysis/dowtheory3-print.html (5 of 10) [2/18/2003 5:29:58 AM]

StockCharts.com - Dow Theory Part 3

Combining the guidelines set forth for trend identification with the theorem on confirmation, it is now possible to classify the primary trend of the market. The chart above shows an array of signals that occurred during a 7-month period in 1998. 1. In April, both the DJIA and DJTA recorded new all-time highs (blue line). The primary trend was already bullish, but this confirmation validated the primary trend as bullish. 2. In July, trouble began to surface when the DJTA failed to confirm the new high set by the DJIA. This served as a warning sign, but did not change the trend. Remember, the trend is assumed to be in force until proven otherwise. 3. On July 31, the DJTA recorded a new reaction low. Two days later, the DJIA recorded a new reaction low and confirmed a change in the primary trend from http://www.stockcharts.com/education/What/MarketAnalysis/dowtheory3-print.html (6 of 10) [2/18/2003 5:29:58 AM]

StockCharts.com - Dow Theory Part 3

bullish to bearish (red line). After this signal, both averages went on to record new reaction lows. 4. In October, the DJIA formed a higher low while the DJTA recorded a new low. This was another non-confirmation and served notice to be on guard for a possible change in trend. 5. After the higher low, the DJIA followed through with a higher high later that month. This effectively changes the trend for the average from down to up. 6. It was not until early November that the DJTA went on to better its previous reaction high. However, at the same time the DJIA was also advancing higher and the primary trend had changed from bearish to bullish. Volume

The importance of volume was alluded to in part 2 with the chart of the Apr-97 bottom in the DJIA. Rhea notes that while Hamilton did analyze volume statistics, price action was the ultimate determinant. Volume is more important when confirming the strength of advances and can also help to identify potential reversals. Volume Confirmation Hamilton thought that volume should increase in the direction of the primary trend. In a primary bull market, volume should be heavier on advances than during corrections. Not only should volume decline on corrections, but participation should also decrease. As Hamilton put it, the market should become "dull and narrow" on corrections, "narrow" meaning that the number of declining issues should not be expanding dramatically. The opposite is true in a primary bear market. Volume should increase on the declines and decrease during the reaction rallies. The reaction rallies should also be narrow and reflect poor participation of the broader market. By analyzing the reaction rallies and corrections, it is possible to judge the underlying strength of the primary trend. Volume and Reversals Hamilton noted that high volume levels could be indicative of an impending reversal. A high volume day after a long advance may signal that the trend is about to change or that a reaction high may form soon. In his StockCharts.com commentary on 25-Jun-99, Rex Takasugi discusses the correlation between volume and peaks in the market. Even though his analysis reveals a lag time between volume peaks and market reversals, the relationship still exists. Takasugi's analysis reveals that since 1900 there have been 14 cycles and volume peaked on average 5.6 months ahead of the market. He also notes that the most recent volume peak occurred in Apr-99. Trading Ranges a.k.a. Lines

In his commentaries over the years, Hamilton referred many times to "lines." Lines are horizontal lines that form trading ranges. Trading ranges develop when the averages http://www.stockcharts.com/education/What/MarketAnalysis/dowtheory3-print.html (7 of 10) [2/18/2003 5:29:58 AM]

StockCharts.com - Dow Theory Part 3

move sideways over a period of time and make it possible to draw horizontal lines connecting the tops and bottoms. These trading ranges indicate either accumulation or distribution, but it was virtually impossible to tell which until there was a break to the upside or the downside. If there were a break to the upside, then the trading range would be considered an area of accumulation. If there were a break to the downside, then the trading range would be considered an area of distribution. Hamilton considered the trading range neutral until a breakout occurred. He also warned against attempting to anticipate the breakout.

Performance of the Dow Theory

Mark Hulbert, writing in the New York Times - 6-Sept-98, notes a study that was published in the Journal of Finance by Stephen Brown of New York University and William Goetzmann and Alok Kumar of Yale. They developed a neural network that incorporated the rules for identifying the primary trend. The Dow theory system was tested against buy-and-hold for the period from 1929 to Sept-98. When the system identified the primary trend as bullish, a long position was initiated in a hypothetical index fund. When the system signaled a bearish primary trend, stocks were sold and the money was placed in fixed income instruments. By taking money out of stocks after bear signals, the risk (volatility) of the portfolio is significantly reduced. This is a very important aspect of the Dow theory system and portfolio management. In the past few years, the concept of risk in stocks has diminished, but it is still a fact that stocks carry more risk than bonds. Over the 70-year period, the Dow theory system outperformed a buy-and-hold strategy http://www.stockcharts.com/education/What/MarketAnalysis/dowtheory3-print.html (8 of 10) [2/18/2003 5:29:58 AM]

StockCharts.com - Dow Theory Part 3

by about 2% per year. In addition, the portfolio carried significantly less risk. If compared as risk-adjusted returns, the margin of outperformance would increase. Over the past 18 years, the Dow theory system has underperformed the market by about 2.6% per year. However, when adjusted for risk, the Dow theory system outperformed buy-and-hold over the past 18 years. Keep in mind that 18 years is not a long time in the history of the market. The Dow theory system was found to underperform during bull markets and outperform during bear markets. Criticisms of Dow Theory

The first criticism of the Dow theory is that it is really not a theory. Neither Dow nor Hamilton wrote proper academic papers outlining the theory and testing the theorems. The ideas of Dow and Hamilton were put forth through their editorials in the Wall Street Journal. Robert Rhea stitched the theory together by poring over these writings. Secondly, the Dow theory is criticized for being too late. The trend does not change from bearish to bullish until the previous reaction high has been surpassed. Many traders feel that this is simply too late and misses much of the move. Dow and Hamilton sought to catch the meat of the move and enter during the second leg. Even though this is where the bulk of the move will take place, it is also after the first leg and part way into the second leg. And, if one has to wait for confirmation from the other average, it could even be later in the move. Thirdly, because it uses the DJIA and DJTA, the Dow theory is criticized as being outdated and no longer an accurate reflection of the economy. This may be a valid point, but as outlined earlier, the DJTA is one of the most economically sensitive indices. The stock market has always been seen as a great predictor of economic growth. To at least keep the industrials up to speed, Home Depot, Intel, Microsoft and SBC Corp have been added to the average to replace Chevron, Goodyear, Sears and Union Carbide, as of 1-Nov-99. Conclusions

The goal of Dow and Hamilton was to identify the primary trend and catch the big moves. They understood that the market was influenced by emotion and prone to overreaction both up and down. With this in mind, they concentrated on identification and following: identify the trend and then follow the trend. The trend is in place until proven otherwise. That is when the trend will end, when it is proven otherwise. Dow theory helps investors identify facts, not make assumptions or forecast. It can be dangerous when investors and traders begin to assume. Predicting the market is a difficult, if not impossible, game. Hamilton readily admitted that the Dow theory was not infallible. While Dow theory may be able to form the foundation for analysis, it is meant as a starting point for investors and traders to develop analysis guidelines that they are http://www.stockcharts.com/education/What/MarketAnalysis/dowtheory3-print.html (9 of 10) [2/18/2003 5:29:58 AM]

StockCharts.com - Dow Theory Part 3

comfortable with and understand. Reading the markets is an empirical science. As such there will be exceptions to the theorems put forth by Hamilton and Dow. They believed that success in the markets required serious study and analysis that would be fraught with successes and failures. Success is a great thing, but don't get too smug about it. Failures, while painful, should be looked upon as learning experiences. Technical analysis is an art form and the eye grows keener with practice. Study both successes and failures with an eye to the future.

Written by Arthur Hill

Send us your Feedback!

©2002 StockCharts.com All Rights Reserved Terms of Use

http://www.stockcharts.com/education/What/MarketAnalysis/dowtheory3-print.html (10 of 10) [2/18/2003 5:29:58 AM]

StockCharts.com - Elliot Wave Theory

Elliot Wave Theory R. N. Elliott believed markets had well-defined waves that could be used to predict market direction. In 1939, Elliott detailed the Elliott Wave Theory, which states that stock prices are governed by cycles founded upon the Fibonacci series (1-2-3-5-8-1321...). According to the Elliott Wave Theory, stock prices tend to move in a predetermined number of waves consistent with the Fibonacci series. Specifically, Elliott believed the market moved in five distinct waves on the upside and three distinct on the downside. The basic shape of the wave is shown below.

Waves one, three and five represent the 'impulse', or minor upwaves in a major bull move. Waves two and four represent the 'corrective,' or minor downwaves in the major bull move. The waves lettered A and C represents the minor downwaves in a major bear move, while B represents the one upwave in a minor bear wave. Elliott proposed that the waves existed at many levels, meaning there could be waves within waves. To clarify, this means that the chart above not only represents the http://www.stockcharts.com/education/What/MarketAnalysis/elliotwavetheory-print.html (1 of 4) [2/18/2003 5:30:08 AM]

StockCharts.com - Elliot Wave Theory

primary wave pattern, but it could also represent what occurs just between points 2 and 4. The diagram below shows how primary waves could be broken down into smaller waves.

Elliott Wave theory ascribes names to the waves in order of descending size: 1. 2. 3. 4. 5. 6. 7. 8. 9.

Grand Supercycle Supercycle Cycle Primary Intermediate Minor Minute Minuette Sub-Minuette

The major waves determine the major trend of the market, and minor waves determine minor trends. This is similar to the manner in which Dow Theory postulates primary and secondary trends. Elliott provided numerous variations on the main wave, and placed particular importance on the golden mean, 0.618, as a significant percentage for retracement. Trading using Elliott Wave patterns is quite simple. The trader identifies the main wave or supercycle, enters long, and then sells or shorts, as the reversal is determined. This continues in progressively shorter cycles until the cycle completes and the main wave resurfaces. The caution to this is that much of the wave identification is taken in

http://www.stockcharts.com/education/What/MarketAnalysis/elliotwavetheory-print.html (2 of 4) [2/18/2003 5:30:08 AM]

StockCharts.com - Elliot Wave Theory

hindsight and disagreements arise between Elliott Wave technicians as to which cycle the market is in. Here is an example of a classic Elliott Wave cycle that occurred in Homestake Mines (HM) over the course of 1993 and 1994.

For more information, check out Elliott Wave Principle: Key to Market Behavior by Robert Prechter.

Written by Scott McCormick

http://www.stockcharts.com/education/What/MarketAnalysis/elliotwavetheory-print.html (3 of 4) [2/18/2003 5:30:08 AM]

StockCharts.com - Elliot Wave Theory

Send us your Feedback!

©2002 StockCharts.com All Rights Reserved Terms of Use

http://www.stockcharts.com/education/What/MarketAnalysis/elliotwavetheory-print.html (4 of 4) [2/18/2003 5:30:08 AM]

Trading Strategies -- Chart School

SharpChart: Symbol Catalog

You are logged out Log in

You are here: Chart School > What is TA? > Trading Strategies

Search the Site:

Advanced Search

Trading Strategies

Chart School Technical Analysis Overview Chart Analysis Indicator Analysis Market Analysis Trading Strategies Analysis Tools SharpCharts PerfCharts Point & Figure Charts Stock Scans Market Carpet Additional Resources Bookstore Glossary Newsletter Archives Mailbag Articles Using StockCharts.com Recommended Sites

John Murphy's Ten Laws of Technical Trading-

Richard Rhodes' Trading Rules-

It sounds like a cliché, but simple methods work best. Richard reveals his 18 simple strategies to making money in the stock market.

The "Last" Stochastic Technique-

Stochastic signals can be erratic. A technique that uses an unsmoothed 39 day stochastic has been found to give good signals, when combined with a volume-based indicator such as OBV.

Join Now! Arthur Hill on Goals, Style and Strategy-

Our Bookstore Books on: Our Favorites Technical Analysis Books by John Murphy P&F Charting General Investing

John Murphy draws upon his thirty years of experience in the field to develop ten basic laws of technical trading. These precepts define the key tools of technical analysis and how to use them to identify buying and selling opportunities.

Arthur Hill examines goals, ideas, and strategies on trading stocks. Before investing or trading, it is important to develop a strategy or game plan that is consistent with your goals and style. The ultimate goal is to make money (win), but there are many different methods to go about it.

http://www.stockcharts.com/education/What/TradingStrategies/index.html (1 of 2) [2/18/2003 5:30:17 AM]

Trading Strategies -- Chart School

Arthur Hill on On Moving Average Crossovers-

Scott McCormick's Gap Trading Strategies-

Arthur Hill examines using a trading system built on moving average crossovers. A trading system using two moving averages would give a buy signal when the shorter (faster) moving average advances above the longer (slower) moving average. A sell signal would be given when the shorter moving average crosses below the longer moving average. Gap trading is a simple and disciplined approach to buying and shorting stocks. One can find stocks that have a price gap from the previous close and watch the first hour of trading to identify trading range. Part 1

The Pre-Holiday Effect-

Part 2

Historical research shows that stock prices often behave in a specific manner in each of the two trading days preceding the nine major holidays that the market is closed. By becoming aware of this behavior, both short-term traders and longer-term investors can benefit.

Financial Ad Trader

Join Now! | Newsletter | FAQ | Glossary | Terms of Use Home | Free Charts | Chart School | Members | Support Data provided by: Unless otherwise indicated, all data is delayed by 20 minutes ©1999-2003 StockCharts.com All Rights Reserved

http://www.stockcharts.com/education/What/TradingStrategies/index.html (2 of 2) [2/18/2003 5:30:17 AM]

StockCharts.com - John Murphy's Ten Laws of Technical Trading

John Murphy's Ten Laws of Technical Trading John Murphy is a very popular author, columnist, and speaker on the subject of Technical Analysis. StockCharts.com is very glad to include his Ten Laws of Technical Trading in our educational material. If you find this information useful, please visit the MurphyMorris web site for additional examples of John's insight.

Print Version John Murphy's Ten Laws of Technical Trading Which way is the market moving? How far up or down will it go? And when will it go the other way? These are the basic concerns of the technical analyst. Behind the charts and graphs and mathematical formulas used to analyze market trends are some basic concepts that apply to most of the theories employed by today's technical analysts. John Murphy, a leader in technical analysis of futures markets, has drawn upon his thirty years of experience in the field to develop ten basic laws of technical trading: rules that are designed to help explain the whole idea of technical trading for the beginner and to streamline the trading methodology for the more experienced practitioner. These precepts define the key tools of technical analysis and how to use them to identify buying and selling opportunities. Mr. Murphy was the technical analyst for CNBC-TV for seven years on the popular show "Tech Talk" and has authored three best-selling books on the subject -- Technical Analysis of the Financial Markets, Intermarket Technical Analysis and The Visual Investor. His most recent book demonstrates the essential "visual" elements of technical analysis. The fundamentals of Mr. Murphy's approach to technical analysis illustrate that it is more important to determine where a market is going (up or down) rather than the why behind it. The following are Mr. Murphy's ten most important rules of technical trading:

1. 2. 3. 4.

Map the Trends Spot the Trend and Go With It Find the Low and High of It Know How Far to Backtrack

http://www.stockcharts.com/education/What/TradingStrategies/MurphysLaws-print.html (1 of 5) [2/18/2003 5:30:26 AM]

StockCharts.com - John Murphy's Ten Laws of Technical Trading

5. 6. 7. 8. 9. 10.

Draw the Line Follow That Average Learn the Turns Know the Warning Signs Trend or Not a Trend? Know the Confirming Signs

1. Map the Trends Study long-term charts. Begin a chart analysis with monthly and weekly charts spanning several years. A larger scale "map of the market" provides more visibility and a better longterm perspective on a market. Once the long-term has been established, then consult daily and intra-day charts. A short-term market view alone can often be deceptive. Even if you only trade the very short term, you will do better if you're trading in the same direction as the intermediate and longer term trends. 2. Spot the Trend and Go With It Determine the trend and follow it. Market trends come in many sizes -- long-term, intermediateterm and short-term. First, determine which one you're going to trade and use the appropriate chart. Make sure you trade in the direction of that trend. Buy dips if the trend is up. Sell rallies if the trend is down. If you're trading the intermediate trend, use daily and weekly charts. If you're day trading, use daily and intra-day charts. But in each case, let the longer range chart determine the trend, and then use the shorter term chart for timing. 3. Find the Low and High of It Find support and resistance levels. The best place to buy a market is near support levels. That support is usually a previous reaction low. The best place to sell a market is near resistance levels. Resistance is usually a previous peak. After a resistance peak has been broken, it will usually provide support on subsequent pullbacks. In other words, the old "high" becomes the new "low." In the same way, when a support level has been broken, it will usually produce selling on subsequent rallies -- the old "low" can become the new "high." 4. Know How Far to Backtrack Measure percentage retracements. Market corrections up or down usually retrace a significant portion of the previous trend. You can measure the corrections in an existing trend in simple percentages. A fifty percent retracement of a prior trend is most common. A minimum retracement is usually one-third of the prior trend. The maximum retracement is usually twothirds. Fibonacci retracements of 38% and 62% are also worth watching. During a pullback in an uptrend, therefore, initial buy points are in the 33-38% retracement area. 5. Draw the Line Draw trend lines. Trend lines are one of the simplest and most effective charting tools. All you http://www.stockcharts.com/education/What/TradingStrategies/MurphysLaws-print.html (2 of 5) [2/18/2003 5:30:26 AM]

StockCharts.com - John Murphy's Ten Laws of Technical Trading

need is a straight edge and two points on the chart. Up trend lines are drawn along two successive lows. Down trend lines are drawn along two successive peaks. Prices will often pull back to trend lines before resuming their trend. The breaking of trend lines usually signals a change in trend. A valid trend line should be touched at least three times. The longer a trend line has been in effect, and the more times it has been tested, the more important it becomes. 6. Follow that Average Follow moving averages. Moving averages provide objective buy and sell signals. They tell you if existing trend is still in motion and help confirm a trend change. Moving averages do not tell you in advance, however, that a trend change is imminent. A combination chart of two moving averages is the most popular way of finding trading signals. Some popular futures combinations are 4- and 9-day moving averages, 9- and 18-day, 5- and 20-day. Signals are given when the shorter average line crosses the longer. Price crossings above and below a 40-day moving average also provide good trading signals. Since moving average chart lines are trend-following indicators, they work best in a trending market. 7. Learn the Turns Track oscillators. Oscillators help identify overbought and oversold markets. While moving averages offer confirmation of a market trend change, oscillators often help warn us in advance that a market has rallied or fallen too far and will soon turn. Two of the most popular are the Relative Strength Index (RSI) and Stochastics. They both work on a scale of 0 to 100. With the RSI, readings over 70 are overbought while readings below 30 are oversold. The overbought and oversold values for Stochastics are 80 and 20. Most traders use 14-days or weeks for stochastics and either 9 or 14 days or weeks for RSI. Oscillator divergences often warn of market turns. These tools work best in a trading market range. Weekly signals can be used as filters on daily signals. Daily signals can be used as filters for intra-day charts. 8. Know the Warning Signs Trade MACD. The Moving Average Convergence Divergence (MACD) indicator (developed by Gerald Appel) combines a moving average crossover system with the overbought/oversold elements of an oscillator. A buy signal occurs when the faster line crosses above the slower and both lines are below zero. A sell signal takes place when the faster line crosses below the slower from above the zero line. Weekly signals take precedence over daily signals. An MACD histogram plots the difference between the two lines and gives even earlier warnings of trend changes. It's called a "histogram" because vertical bars are used to show the difference between the two lines on the chart. 9. Trend or Not a Trend Use ADX. The Average Directional Movement Index (ADX) line helps determine whether a market is in a trending or a trading phase. It measures the degree of trend or direction in the market. A rising ADX line suggests the presence of a strong trend. A falling ADX line suggests the presence of a trading market and the absence of a trend. A rising ADX line favors moving averages; a falling ADX favors oscillators. By plotting the direction of the ADX line, the trader is http://www.stockcharts.com/education/What/TradingStrategies/MurphysLaws-print.html (3 of 5) [2/18/2003 5:30:26 AM]

StockCharts.com - John Murphy's Ten Laws of Technical Trading

able to determine which trading style and which set of indicators are most suitable for the current market environment. 10. Know the Confirming Signs Include volume and open interest. Volume and open interest are important confirming indicators in futures markets. Volume precedes price. It's important to ensure that heavier volume is taking place in the direction of the prevailing trend. In an uptrend, heavier volume should be seen on up days. Rising open interest confirms that new money is supporting the prevailing trend. Declining open interest is often a warning that the trend is near completion. A solid price uptrend should be accompanied by rising volume and rising open interest. "11." Technical analysis is a skill that improves with experience and study. Always be a student and keep learning. - John Murphy

Important Disclaimer: The views expressed within are solely those of the author. Futures and options trading involves risk and is not suitable for everyone. Commission rates and fees vary. Examples and descriptions are not intended to serve as advice and cannot be the basis for any claim. While every effort has been made to ensure the accuracy of the material contained in the book, neither author or publisher can be held liable for errors or omissions. Contact a licensed commodities broker for more information. Definitions: Leonardo Fibonacci was a thirteenth century mathematician who "rediscovered" a precise and almost constant relationship between Hindu-Arabic numbers in a sequence (1,1,2,3,5,8,13,21,34,55,89,144,etc. to infinity). The sum of any two consecutive numbers in this sequence equals the next higher number. After the first four, the ratio of any number in the sequence to its next higher number approaches .618. That ratio was known to the ancient Greek and Egyptian mathematicians as the "Golden Mean" which had critical applications in art, architecture and in nature. Stochastics - an oscillator popularized by George Lane in an article on the subject which appeared in 1984. It is based on the observation that as prices increase, closing prices tend to be closer to the upper end of the price range; conversely, in down trends, closing prices tend to be near the lower end of the range. Stochastics has slightly wider overbought and oversold boundaries than the RSI and is therefore a more volatile indicator. The term "stochastic" refers to the location of a current futures price in relation to its range over a set period of time (usually 14 days).

http://www.stockcharts.com/education/What/TradingStrategies/MurphysLaws-print.html (4 of 5) [2/18/2003 5:30:26 AM]

StockCharts.com - John Murphy's Ten Laws of Technical Trading

©2002 StockCharts.com All Rights Reserved Terms of Use

http://www.stockcharts.com/education/What/TradingStrategies/MurphysLaws-print.html (5 of 5) [2/18/2003 5:30:26 AM]

StockCharts.com - Arthur Hill On Goals, Style and Strategy

Arthur Hill On Goals, Style and Strategy Before investing or trading, it is important to develop a strategy or game plan that is consistent with your goals and style. The ultimate goal is to make money (win), but there are many different methods to go about it. As with many aspects of trading, many sports offer a good analogy. A football team with goals geared towards ball control and low-scoring games might adapt a conservative style that focuses on the run. Teams that want to score often and score quickly are more likely to pursue an aggressive style geared towards passing. Teams are usually aware of their goal and style before they develop a game plan. Investors and traders can also benefit by keeping in mind their goals and style when developing a strategy. Goals First and foremost are goals. The first set of questions regarding goals should center on risk and return. One cannot consider return without weighing risk. It is akin to counting your chickens before they are hatched. Risk and return are highly correlated. The higher the potential return, the higher the potential risk. At one end of the spectrum are US Treasury bonds, which offer the lowest risk (so-called risk free rate) and a guaranteed return. For stocks, the highest potential returns (and risk) center around growth industries with stock prices that exhibit high volatility and high price multiples (PE, Price/Sales, Price/Hope). The lowest potential returns (and risk) come from stocks in mature industries with stock prices that exhibit relatively low volatility and low price multiples. Style After your goals have been established, it is time to develop or choose a style that is consistent with achieving those goals. The expected return and desired risk will affect your trading or investing style. If your goal is income and safety, buying or selling at extreme levels (overbought/oversold) is an unlikely style. If your goals center on quick profits, high returns and high risk, then bottom picking strategies and gap trading may be your style. Styles range from aggressive day traders looking to scalp 1/4-1/2 point gains to investors looking to capitalize on long-term macro economic trends. In between, there are a whole host of possible combinations including swing traders, position traders, aggressive growth investors, value investors and contrarians. Swing traders might look for 1-5 day trades, position traders for 1-8 week trades and value investors for 1-2 year trades.

http://www.stockcharts.com/education/What/TradingStrategies/AHillTradingStrategy-print.html (1 of 3) [2/18/2003 5:30:34 AM]

StockCharts.com - Arthur Hill On Goals, Style and Strategy

Not only will your style depend on your goals, but also on your level of commitment. Day traders are likely to pursue an aggressive style with high activity levels. The goals would be focused on quick trades, small profits and very tight stop-loss levels. Intraday charts would be used to provide timely entry and exit points. A high level of commitment, focus and energy would be required. On the other hand, position traders are likely to use daily end-of-day charts and pursue 1-8 week price movements. The goal would be focused on short to intermediate price movements and the level of commitment, while still substantial, would be less than a day trader. Make sure your level of commitment jibes with your trading style. The more trading involved, the higher the level of commitment. Strategy Once the goals have been set and preferred style adopted, it is time to develop a strategy. This strategy would be based on your return/risk preferences, trading/investing style and commitment level. Because there are many potential trading and investing strategies, I am going to focus on one hypothetical strategy as an example. GOAL: First, the goal would be a 20-30% annual return. This is quite high and would involve a correspondingly high level of risk. Because of the associated risk, I would only allot a small percentage (5-10%) of my portfolio to this strategy. The remaining portion would go towards a more conservative approach. STYLE: Although I like to follow the market throughout the day, I cannot make the commitment to day trading and use of intraday charts. I would pursue a position trading style and look for 1-8 week price movements based on end-of-day charts. Indicators will be limited to three with price action (candlesticks) and chart patterns will carry the most influence. Part of this style would involve a strict money management scheme that would limit losses by imposing a stop-loss immediately after a trade is initiated. An exit strategy must be in place before the trade is initiated. Should the trade become a winner, the exit strategy would be revised to lock in gains. The maximum allowed per trade would be 5% of my total trading capital. If my total portfolio were 300,000, then I might allocate 21,000 (7%) to the trading portfolio. Of this 21,000, the maximum allowed per trade would be 1050 (21,000 * 5%). STRATEGY: The trading strategy is to go long stocks that are near support levels and short stocks near resistance levels. To maintain prudence, I would only seek long positions in stocks with weekly (long-term) bull trends and short positions in stocks with weekly (long-term) bear trends. In addition, I would look for stocks that are starting to show positive (or negative) divergences in key momentum indicators as well as signs of accumulation (or distribution). My indicator arsenal would consist of two momentum

http://www.stockcharts.com/education/What/TradingStrategies/AHillTradingStrategy-print.html (2 of 3) [2/18/2003 5:30:34 AM]

StockCharts.com - Arthur Hill On Goals, Style and Strategy

indicators (PPO and Slow Stochastic Oscillator) and one volume indicator (Accumulation/Distribution Line). Even though the PPO and the Slow Stochastic Oscillator are momentum oscillators, one is geared towards the direction of momentum (PPO) and the other towards identifying overbought and oversold levels (Slow Stochastic Oscillator). As triggers, I would use key candlestick patterns, price reversals and gaps to enter a trade. This is just one hypothetical strategy that combines goals with style and commitment. Some people have different portfolios that represent different goals, styles and strategies. While this can become confusing and quite time consuming, separate portfolios ensure that investment activities pursue a different strategy than trading activities. For instance, you may pursue an aggressive (high-risk) strategy for trading with a small portion of your portfolio and a relatively conservative (capital preservation) strategy for investing with the bulk of your portfolio. If a small percentage (~5-10%) is earmarked for trading and the bulk (~90-95%) for investing, the equity swings should be lower and the emotional strains less. However, if too much of a portfolio (~50-60%) is at risk through aggressive trading, the equity swings and the emotional strain could be large.

Written by Arthur Hill

Send us your Feedback!

©2002 StockCharts.com All Rights Reserved Terms of Use

http://www.stockcharts.com/education/What/TradingStrategies/AHillTradingStrategy-print.html (3 of 3) [2/18/2003 5:30:34 AM]

StockCharts.com - Arthur Hill On Moving Average Crossovers

Arthur Hill On Moving Average Crossovers A popular use for moving averages is to develop simple trading systems based on moving average crossovers. A trading system using two moving averages would give a buy signal when the shorter (faster) moving average advances above the longer (slower) moving average. A sell signal would be given when the shorter moving average crosses below the longer moving average. The speed of the systems and the number of signals generated will depend on the length of the moving averages. Shorter moving average systems will be faster, generate more signals and be nimble for early entry. However, they will also generate more false signals than systems with longer moving averages. XIRC

http://www.stockcharts.com/education/What/TradingStrategies/AHillMAcrossover-print.html (1 of 4) [2/18/2003 5:30:43 AM]

StockCharts.com - Arthur Hill On Moving Average Crossovers

For Xircom, a 30/100 exponential moving average crossover was used to generate signals. When the 30-day EMA moves above the 100-day EMA, a buy signal is in force. When the 30-day EMA declines below the 100-day EMA, a sell signal is in force. A plot of the 30/100 differential is shown below the price chart by using the Percentage Price Oscillator (PPO) set to (30,100,1). When the differential is positive, the 30-day EMA is greater than the 100-day EMA. When it is negative, the 30-day EMA is less than the 100day EMA. As with all trend-following systems, the signals work well when the stock develops a strong trend, but are ineffective when the stock is in a trading range. Some good entry points for long positions were caught in Sept-97, Mar-98 and Jul-99. However, an exit strategy based on the moving average crossover would have given back some of those profits. All in all, though, the system would have been profitable for the time period http://www.stockcharts.com/education/What/TradingStrategies/AHillMAcrossover-print.html (2 of 4) [2/18/2003 5:30:43 AM]

StockCharts.com - Arthur Hill On Moving Average Crossovers

shown. 3COM

In the example for 3Com, a 20/60 EMA crossover system was used to generate buy and sell signals. The plot below the price is the 20/60 EMA differential, which is shown as a percent and displayed using the Percentage Price Oscillator (PPO) set at (20,60,1). The thin blue lines just above and below zero (the centerline) represent the buy and sell trigger points. Using zero as the crossover point for the buy and sell signals generated too many false signals. Therefore, the buy signal was set just above the zero line (at +2%) and the sell signal was set just below the zero line (at -2%). When the 20-day EMA is more than 2% above the 60-day EMA, a buy signal is in force. When the 20-day EMA is more than 2% below the 60-day EMA, a sell signal is in force.

http://www.stockcharts.com/education/What/TradingStrategies/AHillMAcrossover-print.html (3 of 4) [2/18/2003 5:30:43 AM]

StockCharts.com - Arthur Hill On Moving Average Crossovers

There were a few good signals, but also a number of whipsaws. Although much would depend on the exact entry and exit points, I believe that a profit could have been made using this system, but not a large profit and probably not enough to justify the risk. The stock failed to hold a trend and tight stop-losses would have been required to lock in profits. A trailing stop or use of the parabolic SAR might have helped lock in profits. Moving average crossover systems can be effective, but should be used in conjunction with other aspects of technical analysis (patterns, candlesticks, momentum, volume, and so on). While it is easy to find a system that worked well in the past, there is no guarantee that it will work in the future.

Written by Arthur Hill

Send us your Feedback!

©2002 StockCharts.com All Rights Reserved Terms of Use

http://www.stockcharts.com/education/What/TradingStrategies/AHillMAcrossover-print.html (4 of 4) [2/18/2003 5:30:43 AM]

StockCharts.com - Gap Trading Strategies - Part 1

Gap Trading Strategies - Part 1 Gap trading is a simple and disciplined approach to buying and shorting stocks. Essentially one finds stocks that have a price gap from the previous close and watches the first hour of trading to identify the trading range. Rising above that range signals a buy, and falling below it signals a short. What is a Gap?

A gap is a change in price levels between the close and open of two consecutive days. Although most technical analysis manuals define the four types of gap patterns as Common, Breakaway, Continuation and Exhaustion, those labels are applied after the chart pattern is established. That is, the difference between any one type of gap from another is only distinguishable after the stock continues up or down in some fashion. Although those classifications are useful for a longer-term understanding of how a particular stock or sector reacts, they offer little guidance for trading. For trading purposes, we define four basic types of gaps as follows: A Full Gap Up occurs when the opening price is greater than yesterday's high price. In the chart below for Cisco, the open price for June 2, indicated by the small tick mark to the left of the second bar in June (green arrow), is higher than the previous day's close, shown by the right-side tick mark on the June 1 bar.

http://www.stockcharts.com/education/What/TradingStrategies/gapStrategies1-print.html (1 of 16) [2/18/2003 5:31:01 AM]

StockCharts.com - Gap Trading Strategies - Part 1

A Full Gap Down occurs when the opening price is less than yesterday's low. The chart for Lycos, below, shows both a full gap up on May 16 (green arrow) and a full gap down the next day (red arrow).

A Partial Gap Up occurs when today's opening price is higher than yesterday's close,

http://www.stockcharts.com/education/What/TradingStrategies/gapStrategies1-print.html (2 of 16) [2/18/2003 5:31:01 AM]

StockCharts.com - Gap Trading Strategies - Part 1

but not higher than yesterday's high. The next chart for Earthlink depicts the partial gap up on June 1 (red arrow), and the full gap up on June 2 (green arrow).

A Partial Gap Down occurs when the opening price is below yesterday's close, but not below yesterday's low. The red arrow on the chart for Offshore Logistics, below, shows where the stock opened below the previous close, but not below the previous low.

http://www.stockcharts.com/education/What/TradingStrategies/gapStrategies1-print.html (3 of 16) [2/18/2003 5:31:01 AM]

StockCharts.com - Gap Trading Strategies - Part 1

For the bulk of this tutorial, intraday charts of 2, 5 or 10 days will be used to demonstrate entry and exit signals for long and short positions. Notice that the intraday chart (below) is graphed slightly differently, showing a composite of the trades occurring every 15 minutes. Although a trade-by-trade intraday charting tool would show the exact bid and ask spread, this tutorial will refer to the left-side horizontal line of each bar as the open, and the right side horizontal bar as the close of each trade.

http://www.stockcharts.com/education/What/TradingStrategies/gapStrategies1-print.html (4 of 16) [2/18/2003 5:31:01 AM]

StockCharts.com - Gap Trading Strategies - Part 1

The beige vertical double lines represent day-to-day breaks, and the single beige vertical lines represent one or two hour divisions. Reference the time scale at the bottom of each chart. Why Use Trading Rules?

In order to successfully trade gapping stocks, one should use a disciplined set of entry and exit rules to signal trades and minimize risk. Additionally, gap trading strategies can be applied to weekly, end-of-day, or intraday gaps. It is important for longer-term investors to understand the mechanics of gaps, as the 'short' signals can be used as the exit signal to sell holdings. The Gap Trading Strategies

Each of the four gap types has a long and short trading signal, defining the eight gap trading strategies. The basic tenet of gap trading is to allow one hour after the market opens for the stock price to establish its range. A Modified Trading Method, to be discussed later, can be used with any of the eight primary strategies to trigger trades before the first hour, although it involves more risk. Once a position is entered, you calculate and set an 8% trailing stop to exit a long position, and a 4% trailing stop to exit a short position. A trailing stop is simply an exit threshold that follows the rising price or falling price in the case of short positions. http://www.stockcharts.com/education/What/TradingStrategies/gapStrategies1-print.html (5 of 16) [2/18/2003 5:31:01 AM]

StockCharts.com - Gap Trading Strategies - Part 1

Long Example: You buy a stock at $100. You set the exit at no more than 8% below that, or $92. If the price rises to $120, you raise the stop to $110.375, which is approximately 8% below $120. The stop keeps rising as long as the stock price rises. In this manner, you follow the rise in stock price with either a real or mental stop that is executed when the price trend finally reverses. Short Example: You short a stock at $100. You set the Buy-to-Cover at $104 so that a trend reversal of 4% would force you to exit the position. If the price drops to $90, you recalculate the stop at 4% above that number, or $93 to Buy-to-Cover. The eight primary strategies are as follows: Full Gap Up: Long If a stock's opening price is greater than yesterday's high, revisit the 1-minute chart after 10:30 am and set a long (buy) stop two ticks above the high achieved in the first hour of trading. (Note: A 'tick' is defined as the bid/ask spread, usually 1/8 to 1/4 point, depending on the stock.) In the case of CMGI below, the stock gapped open on a Tuesday morning and opened at $46.25. The high reached in the first hour of trading on the day of the gap was $47.50. A buy stop at $47.75, or two 1/8 ticks above the high, would have been triggered shortly before 11:00 am that day. CMGI closed at $51.75 that day, for a $4.00 (8.4%) gain.

http://www.stockcharts.com/education/What/TradingStrategies/gapStrategies1-print.html (6 of 16) [2/18/2003 5:31:01 AM]

StockCharts.com - Gap Trading Strategies - Part 1

An 8% protective sell stop is roughly $44 on the day you entered, and over the next five days rises to $53.875 (which is 8% below the final close of $58.50). At this point, even if the sell stop is triggered, you are up over $6, or 12.5%. At this level of price growth, however, one would normally reduce the sell stop to 5% or less to protect profit. The chart below for AKAM shows that the high of $83.5 was reached by 10:30 am, and a buy signal was generated when that price was broken around 2:15 PM. An entry of $84 would have profited $3 by the close, and the trailing stop would be set at $80 (8% less than the $87 close).

http://www.stockcharts.com/education/What/TradingStrategies/gapStrategies1-print.html (7 of 16) [2/18/2003 5:31:01 AM]

StockCharts.com - Gap Trading Strategies - Part 1

Full Gap Up: Short If the stock gaps up, but there is insufficient buying pressure to sustain the rise, the stock price will level or drop below the opening gap price. Traders can set similar entry signals for short positions as follows: If a stock's opening price is greater than yesterday's high, revisit the 1-minute chart after 10:30 am and set a short stop equal to two ticks below the low achieved in the first hour of trading. In the case of General Electric, it gapped open, and established a low of $53.25 in the first hour of trading. This support level was broken before 11:00 am and would have signaled a short entry at $53. A trailing stop of 4% would set a Buy to Cover limit of $55.125.

http://www.stockcharts.com/education/What/TradingStrategies/gapStrategies1-print.html (8 of 16) [2/18/2003 5:31:01 AM]

StockCharts.com - Gap Trading Strategies - Part 1

Full Gap Down: Long Poor earnings, bad news, organizational changes and market influences can cause a stock's price to drop uncharacteristically. A full gap down occurs when the price is below not only the previous day's close, but the low of the day before as well. A stock whose price opens in a full gap down, then begins to climb immediately, is known as a "Dead Cat Bounce." If a stock's opening price is less than yesterday's low, set a long stop equal to two ticks more than yesterday's low. The Time Warner Telecom chart shows a full gap down 6 days ago at $42, below the previous day's low at $42.50. An entry signal for a long position was signaled with a gap at open to $48, well above the $43 buy stop. This chart illustrates why an immediate entry may be taken at open as long as it has been preceded by an another gap signal. An 8% trailing stop after entry would never have forced an exit, and this trade would be up over 40% in one week.

http://www.stockcharts.com/education/What/TradingStrategies/gapStrategies1-print.html (9 of 16) [2/18/2003 5:31:01 AM]

StockCharts.com - Gap Trading Strategies - Part 1

Full Gap Down: Short If a stock's opening price is less than yesterday's low, revisit the 1-minute chart after 10:30 am and set a short stop equal to two ticks below the low achieved in the first hour of trading. The signal to short General Motors occurs the day after the major gap down at $76. Although a 4% trailing stop would be calculated at $79, the large volume spikes at close and open during the last two days of the chart would reasonably suggest accumulation and that it was time to buy to cover.

http://www.stockcharts.com/education/What/TradingStrategies/gapStrategies1-print.html (10 of 16) [2/18/2003 5:31:01 AM]

StockCharts.com - Gap Trading Strategies - Part 1

Partial Gaps The difference between a Full and Partial Gap is risk and potential gain. In general, a stock gapping completely above the previous day's high has a significant change in the market's desire to own or sell it. Demand is large enough to force the market maker or floor specialist to make a major price change to accommodate the unfilled orders. Full gapping stocks generally trend farther in one direction than stocks which only partially gap. However, a smaller demand may just require the trading floor to only move price above or below the previous close in order to trigger buying or selling to fill on-hand orders. There is a generally a greater opportunity for gain over several days in full gapping stocks. If there is not enough interest in selling or buying a stock after the initial orders are filled, the stock will return to its trading range quickly. Entering a trade for a partially gapping stock generally calls for either greater attention or closer trailing stops of 56%. Partial Gap Up: Long If a stock's opening price is greater than yesterday's close, but not greater than yesterday's high, the condition is considered a Partial Gap Up. The process for a long entry is the same for Full Gaps in that one revisits the 1-minute chart after 10:30 am and set a long (buy) stop two ticks above the high achieved in the first hour of trading.

http://www.stockcharts.com/education/What/TradingStrategies/gapStrategies1-print.html (11 of 16) [2/18/2003 5:31:01 AM]

StockCharts.com - Gap Trading Strategies - Part 1

Parametric Technologies chart gapped above the previous close and broke through the first hour's high around noon. The following three days provided a substantial return.

Starbucks similarly provided a partial gap up and broke through by noon on the day of the gap. It also climbed significantly for the following three days.

http://www.stockcharts.com/education/What/TradingStrategies/gapStrategies1-print.html (12 of 16) [2/18/2003 5:31:01 AM]

StockCharts.com - Gap Trading Strategies - Part 1

Partial Gap Up: Short The short trade process for a partial gap up is the same for Full Gaps in that one revisits the 1-minute chart after 10:30 am and sets a short stop two ticks below the low achieved in the first hour of trading. Perot System's open on the second of the two-day chart below is above the close but not above the high of the previous day. The low by 10:30 am was 15.625, broken at 11:30 am and triggering a short.

http://www.stockcharts.com/education/What/TradingStrategies/gapStrategies1-print.html (13 of 16) [2/18/2003 5:31:01 AM]

StockCharts.com - Gap Trading Strategies - Part 1

Partial Gap Down: Long If a stock's opening price is less than yesterday's close, revisit the 1 minute chart after 10:30 am and set a buy stop two ticks above the high achieved in the first hour of trading. Rudolph Technologies closed at $27.50 and opened at $26.5 the following day. The high by 10:30 am was $30, and that was penetrated just before 11:00 am. A limit buy entry was signaled at $30.25 and the stock closed at $32.

http://www.stockcharts.com/education/What/TradingStrategies/gapStrategies1-print.html (14 of 16) [2/18/2003 5:31:01 AM]

StockCharts.com - Gap Trading Strategies - Part 1

Partial Gap Down: Short The short trade process for a partial gap down is the same for Full Gap Down in that one revisits the 1-minute chart after 10:30AM and sets a short stop two ticks below the low achieved in the first hour of trading. If a stock's opening price is less than yesterday's close, set a short stop equal to two ticks less than the low achieved in the first hour of trading today. Digital Insight closed at $47 and opened as a partial gap down at $46 the following morning. The low by 10:30 am was $45 providing a $44.50 short signal. DGIN sank from that entry and closed $1 lower.

http://www.stockcharts.com/education/What/TradingStrategies/gapStrategies1-print.html (15 of 16) [2/18/2003 5:31:01 AM]

StockCharts.com - Gap Trading Strategies - Part 1

If the volume requirement is not met, the safest way to play a partial gap is to wait until the price breaks the previous high (on a long trade) or low (on a short trade).

Written by Scott McCormick

Part 1 | Part 2

Send us your Feedback!

©2002 StockCharts.com All Rights Reserved Terms of Use

http://www.stockcharts.com/education/What/TradingStrategies/gapStrategies1-print.html (16 of 16) [2/18/2003 5:31:01 AM]

StockCharts.com - Gap Trading Strategies - Part 2

Gap Trading Strategies - Part 2

End-of-day Gap Trading

All eight of the Gap Trading Strategies can be applied to end-of-day trading. One can use either intraday charts, such as the example for INIT below, or daily data charts like the DeBeers chart (DBRSY) further down. The trading strategy to be used should be obvious by now.

http://www.stockcharts.com/education/What/TradingStrategies/gapStrategies2-print.html (1 of 4) [2/18/2003 5:31:11 AM]

StockCharts.com - Gap Trading Strategies - Part 2

Using StockCharts.com's Gap Scans, end-of-day traders can review those stocks with the best potential. Increases in volume for stocks gapping up or down is a strong indication of continued movement in the same direction of the gap. A gapping stock that crosses above resistance levels provides reliable entry signals. Similarly, a short position would be signalled by a stock whose gap down fails support levels. What is the Modified Trading Method?

The Modified Trading Method applies to all eight Full and Partial Gap scenarios above. The only difference is instead of waiting until the price breaks above the high (or below the low for a short); you enter the trade in the middle of the rebound. The other requirement for this method is that the stock should be trading on at least twice the average volume for the last five days. This method is only recommended for those individuals who are proficient with the eight strategies above, and have fast trade execution systems. Since heavy volume trading can experience quick reversals, mental stops are usually used instead of hard stops. Modified Trading Method: Long If a stock's opening price is greater than yesterday's high, revisit the 1 minute chart after 10:30 am and set a long stop equal to the average of the open price and the high price achieved in the first hour of trading. This method recommends that the projected daily volume be double the 5-day average. Modified Trading Method: Short http://www.stockcharts.com/education/What/TradingStrategies/gapStrategies2-print.html (2 of 4) [2/18/2003 5:31:11 AM]

StockCharts.com - Gap Trading Strategies - Part 2

If a stock's opening price is less than yesterday's low, revisit the 1 minute chart after 10:30 am and set a long stop equal to the average of the open and low price achieved in the first hour of trading. This method recommends that the projected daily volume be double the 5-day average. Where do I find gapping stocks?

StockCharts.com publishes lists of stocks that fully gapped up or fully gapped down each day based on end-of-day data. This is an excellent source of ideas for longer term investors. Intuit Corporation acquired Hutchinson Avenue Software Corporation and redeployed the Mach6 application as their QuickQuotesLive product. The Market Trends feature of this application provides timely lists of stocks on all exchanges with Full and Partial Up and Down Gaps, as well as a PreOpen Gap Up and Gap Down listing. ClearStation also provides a list of Stocks gapping up and down for all major US markets under their Most Actives & Price Movers listing. Although these are useful lists of gapping stocks, it is important to look at the longer term charts of the stock to know where the support and resistance may be, and play only those with an average volume above 500,000 shares a day until the gap trading technique is mastered. The most profitable gap plays are normally made on stocks you've followed in the past and are familiar with. How successful is this?

In simple terms, the Gap Trading Strategies are a rigorously defined trading system that uses specific criteria to enter and exit. Trailing stops are defined to limit loss and protect profits. The simplest method for determining your own ability to successfully trade gaps is to paper trade. Paper trading does not involve any real transaction. Instead, one writes down or logs an entry signal and then does the same for an exit signal. Then subtract commissions and slippage to determine your potential profit or loss. Gap trading is much simpler than the length of this tutorial may suggest. You will not find either the tops or bottoms of a stock's price range, but you will be able to profit in a structured manner and minimize losses by using stops. It is, after all, more important to be consistently profitable than to continually chase movers or enter after the crowd.

http://www.stockcharts.com/education/What/TradingStrategies/gapStrategies2-print.html (3 of 4) [2/18/2003 5:31:11 AM]

StockCharts.com - Gap Trading Strategies - Part 2

Written by Scott McCormick

Part 1 | Part 2

Send us your Feedback!

©2002 StockCharts.com All Rights Reserved Terms of Use

http://www.stockcharts.com/education/What/TradingStrategies/gapStrategies2-print.html (4 of 4) [2/18/2003 5:31:11 AM]

StockCharts.com - The Pre-Holiday Effect

The Pre-Holiday Effect Over the past century, there have been nine holidays during which the Exchanges have traditionally been closed. Historical research shows that stock prices often behave in a specific manner in each of the two trading days preceding these holidays. By becoming aware of this behavior, both short-term traders and longer-term investors can benefit. The general strategy is to purchase equities one or two days prior to a holiday. Shortterm traders would look to sell just after the holiday while longer-term investors would wait until year end. Both strategies have proven to be profitable plays. The theory behind this effect is that traders are lightening up their holdings (selling) prior to the three day holiday in order to avoid any unexpected bad news. The selling pressure drives stock prices down, making those days a good opportunity for buying lower in the range. Here is the average pre-holiday results for the last 50 years, based on the S&P 500 Index:

Holiday President's Day*

Buy two days before, Buy one day before, sell at year end sell at year end -0.1%

12.2%

7.3%

17.8%

Memorial Day

-4.7%

22.8%

Independence Day

13.3%

37.3%

Labor Day

16.8%

33.7%

Election Day

17.9%

4.6%

4.3%

1.1%

Christmas

-7.1%

15.2%

New Year's

31.1%

19.6%

Good Friday

Thanksgiving

*Note: President's Day data is comprised of the aggregate of both Washington and Lincoln's Birthday prior to 1998.

The original research was based on the behavior of the S&P 500 Index around the 419

http://www.stockcharts.com/education/What/TradingStrategies/preHolidayEffect-print.html (1 of 6) [2/18/2003 5:31:25 AM]

StockCharts.com - The Pre-Holiday Effect

holiday market closings that occurred from 1928 to 1975. To put those returns in perspective, if you had invested $10,000 in the S&P 500 Index in January 1928 and sold it all in December 1975, you would have ended up with $51,441. However, if you had invested one-ninth of your money just before each preholiday period (selling everything at the end of the year), you would have finished with $1,440,716. Not bad! The Short Term Trading Strategy Short term trading using the this pre-holiday effect can provide excellent results. In the chart for GE, below, we see that a buy near open on June 30th would be accomplished around $49.25. Selling at open on July 5th at $52.50 provided excellent returns.

It is important to note that there are two holidays which often have a partial trading day during the holiday weekend - the day before Independence Day and the day after Thanksgiving. These days usually have a shorten trading session that can be extremely volatile. While they can be traded, volume is always very light and it may be difficult to get limit orders filled. In the chart below for Motorola (MOT), we can see that a buy at $30 on June 30th would have been a flat trade July 3rd, but rose $2 and $3 a share in the two days following the July 4th holiday.

http://www.stockcharts.com/education/What/TradingStrategies/preHolidayEffect-print.html (2 of 6) [2/18/2003 5:31:25 AM]

StockCharts.com - The Pre-Holiday Effect

For VOYN, we have a buy near close at $8, and a sell just after the open on July 5th at $9.5. The volume is less than 100,000 shares on average, and the stock is generally downtrending, but the method is still viable.

The Long Term Trading Strategy http://www.stockcharts.com/education/What/TradingStrategies/preHolidayEffect-print.html (3 of 6) [2/18/2003 5:31:25 AM]

StockCharts.com - The Pre-Holiday Effect

Again, the theory says that stocks generally fall on those days because traders offload their holdings in order to avoid the risk of significant news appearing while the markets are closed. Longer-term investors who are willing to ride out any short-term negative news are rewarded with lower entry prices. Here are four examples from the 2000 Memorial Day holiday (May 26th) where excellent entry points appeared:

http://www.stockcharts.com/education/What/TradingStrategies/preHolidayEffect-print.html (4 of 6) [2/18/2003 5:31:25 AM]

StockCharts.com - The Pre-Holiday Effect

http://www.stockcharts.com/education/What/TradingStrategies/preHolidayEffect-print.html (5 of 6) [2/18/2003 5:31:25 AM]

StockCharts.com - The Pre-Holiday Effect

Investors that took advantage of those dips should be rewarded by year end.

Written by Scott McCormick

Send us your Feedback!

©2002 StockCharts.com All Rights Reserved Terms of Use

http://www.stockcharts.com/education/What/TradingStrategies/preHolidayEffect-print.html (6 of 6) [2/18/2003 5:31:25 AM]

StockCharts.com - The "Last" Stochastic Technique

The "Last" Stochastic Technique The Stochastic oscillator is a momentum or price velocity indicator developed by George Lane. The calculation is very simple:

Where: K = Lane's Stochastic C = latest closing price L = then-period low price H = the n-period high price Additionally, Lane's methods specifically required that the K be smoothed twice with three-period simple moving averages. Two other calculations are then made: SK = three period simple moving average of K SD = three period simple moving average of SK The classic interpretation of a stochastic can be complicated. The basic method is to buy when the SK is above the SD, and sell when the SK moves below the SD. However, the stochastic employs a fixed period-to-period calculation that can move about erratically as the earliest data point is dropped for the next day's calculation. Due to this instability and false signals generated, using a stochastic for entry and exit signals can incur a lot of unprofitable trades. To compensate for this inherent weakness, buy signals are generally reinforced when the crossover occurs in the 10-15% ranges, and sells in the 85-90% range.

http://www.stockcharts.com/education/What/TradingStrategies/lastStochastic-print.html (1 of 7) [2/18/2003 5:31:38 AM]

StockCharts.com - The "Last" Stochastic Technique

Unfortunately, many techniques for using the stochastic oscillator can produce consistent losses over time. Some analysts have recommended smoothing the data further, or looking for a confirming overbought/oversold ratio prior to selling or buying. Most secondary filters such as overbought/oversold indicators degrade the performance of the stochastic in that one does not take advantage of major trends, getting whipsawed in and out. K39 - The Last Stochastic Technique A study published in "The Encyclopedia of Technical Market Indicators" found that some very good signals were given by an unsmoothed 39 period stochastic oscillator (K = 39, no signal line). A buy signal is generated when K crosses above 50% and the closing

http://www.stockcharts.com/education/What/TradingStrategies/lastStochastic-print.html (2 of 7) [2/18/2003 5:31:38 AM]

StockCharts.com - The "Last" Stochastic Technique

price is above the previous week's high close. Sell and/or sell short signals are created when the K line crosses below 50% and the closing price is below the previous week's low close. Taking a longer period, and not smoothing the data over a 3-period moving average allows the analyst to view Lane's Stochastic. Note: You can add the Last Stochastic to our SharpChart charting tool by adding the "Slow Stochastic" indicator with parameters of 39 and 1. Here is an example. Alternately, you can choose "Scott McCormick's Fund Settings" from the "Custom Settings" dropdown. In the chart below for MSFT, we see that the 39 period K crossed above 50% on June 14, at around $72.00.

http://www.stockcharts.com/education/What/TradingStrategies/lastStochastic-print.html (3 of 7) [2/18/2003 5:31:38 AM]

StockCharts.com - The "Last" Stochastic Technique

Weekly, Daily and Hourly through Minute data can all be used effectively for the 39 period stochastic. Using weekly data for three years, we see that the 39-Week Stochastic for MSFT didn't cross below 50% until late February, 2000.

The whipsaw that occured for MSFT the following month shows the need for signal confirmation. If we look at CSCO for the last year on daily data, we see that by the 39 day stochastic, it was a hold from November 1999 at $35 through early April 2000 at $65 a share. Here again, we see a false rally at the end of April. What can be used for confirmation?

http://www.stockcharts.com/education/What/TradingStrategies/lastStochastic-print.html (4 of 7) [2/18/2003 5:31:38 AM]

StockCharts.com - The "Last" Stochastic Technique

Confirmation Since the Stochastic is a price momentum indicator, one should pair it with a volume assessment for trade confirmation. In the chart below, the On Balance Volume (OBV) indicator has been added along with a 30 day MA as a signal line.

http://www.stockcharts.com/education/What/TradingStrategies/lastStochastic-print.html (5 of 7) [2/18/2003 5:31:38 AM]

StockCharts.com - The "Last" Stochastic Technique

Current version of this chart. Notice that there was a bullish OBV crossover in early November 1999 and again in early June 2000 soon after the K line moved back above 50%. Although the Last Stochastic reversed in April, the OBV crossover did not occur. When the K line moved above 50% again in early June, confirmation soon followed. One last point to remember is that all stocks are unique, and while the 39 period Stochastic is a useful technical indicator, one should always map the performance against your specific stock. Recently, most Tech stocks have evidenced a tendency to signal entry at a K crossover above 40% and a sell with K crossing below 60%. However, in volatile equities a second price or sentiment indicator along with a volume indicator provides the best confirmation.

http://www.stockcharts.com/education/What/TradingStrategies/lastStochastic-print.html (6 of 7) [2/18/2003 5:31:38 AM]

StockCharts.com - The "Last" Stochastic Technique

Written by Scott McCormick

Send us your Feedback!

©2002 StockCharts.com All Rights Reserved Terms of Use

http://www.stockcharts.com/education/What/TradingStrategies/lastStochastic-print.html (7 of 7) [2/18/2003 5:31:38 AM]

StockCharts.com - Richard Rhodes' Trading Rules

Richard Rhodes' Trading Rules I must admit, I am not smart enough to have devised these ridiculously simple trading rules. A great trader gave them to me some 15 years ago. However, I will tell you, they work. If you follow these rules, breaking them as infrequently as possible, you will make money year in and year out, some years better than others, some years worse - but you will make money. The rules are simple. Adherence to the rules is difficult. "Old Rules...but Very Good Rules" If I've learned anything in my 17 years of trading, I've learned that the simple methods work best. Those who need to rely upon complex stochastics, linear weighted moving averages, smoothing techniques, fibonacci numbers etc., usually find that they have so many things rolling around in their heads that they cannot make a rational decision. One technique says buy; another says sell. Another says sit tight while another says add to the trade. It sounds like a cliché, but simple methods work best. 1. The first and most important rule is - in bull markets, one is supposed to be long. This may sound obvious, but how many of us have sold the first rally in every bull market, saying that the market has moved too far, too fast. I have before, and I suspect I'll do it again at some point in the future. Thus, we've not enjoyed the profits that should have accrued to us for our initial bullish outlook, but have actually lost money while being short. In a bull market, one can only be long or on the sidelines. Remember, not having a position is a position. 2. Buy that which is showing strength - sell that which is showing weakness. The public continues to buy when prices have fallen. The professional buys because prices have rallied. This difference may not sound logical, but buying strength works. The rule of survival is not to "buy low, sell high", but to "buy higher and sell higher". Furthermore, when comparing various stocks within a group, buy only the strongest and sell the weakest. 3. When putting on a trade, enter it as if it has the potential to be the biggest trade of the year. Don't enter a trade until it has been well thought out, a campaign has been devised for adding to the trade, and contingency plans set for exiting the trade. 4. On minor corrections against the major trend, add to trades. In bull markets, add http://www.stockcharts.com/education/What/TradingStrategies/TradingRules-print.html (1 of 4) [2/18/2003 5:31:46 AM]

StockCharts.com - Richard Rhodes' Trading Rules

to the trade on minor corrections back into support levels. In bear markets, add on corrections into resistance. Use the 33-50% corrections level of the previous movement or the proper moving average as a first point in which to add. 5. Be patient. If a trade is missed, wait for a correction to occur before putting the trade on. 6. Be patient. Once a trade is put on, allow it time to develop and give it time to create the profits you expected. 7. Be patient. The old adage that "you never go broke taking a profit" is maybe the most worthless piece of advice ever given. Taking small profits is the surest way to ultimate loss I can think of, for small profits are never allowed to develop into enormous profits. The real money in trading is made from the one, two or three large trades that develop each year. You must develop the ability to patiently stay with winning trades to allow them to develop into that sort of trade. 8. Be patient. Once a trade is put on, give it time to work; give it time to insulate itself from random noise; give it time for others to see the merit of what you saw earlier than they. 9. Be impatient. As always, small loses and quick losses are the best losses. It is not the loss of money that is important. Rather, it is the mental capital that is used up when you sit with a losing trade that is important. 10. Never, ever under any condition, add to a losing trade, or "average" into a position. If you are buying, then each new buy price must be higher than the previous buy price. If you are selling, then each new selling price must be lower. This rule is to be adhered to without question. 11. Do more of what is working for you, and less of what's not. Each day, look at the various positions you are holding, and try to add to the trade that has the most profit while subtracting from that trade that is either unprofitable or is showing the smallest profit. This is the basis of the old adage, "let your profits run." 12. Don't trade until the technicals and the fundamentals both agree. This rule makes pure technicians cringe. I don't care! I will not trade until I am sure that the simple technical rules I follow, and my fundamental analyses, are running in tandem. Then I can act with authority, and with certainty, and patiently sit tight.

http://www.stockcharts.com/education/What/TradingStrategies/TradingRules-print.html (2 of 4) [2/18/2003 5:31:46 AM]

StockCharts.com - Richard Rhodes' Trading Rules

13. When sharp losses in equity are experienced, take time off. Close all trades and stop trading for several days. The mind can play games with itself following sharp, quick losses. The urge "to get the money back" is extreme, and should not be given in to. 14. When trading well, trade somewhat larger. We all experience those incredible periods of time when all of our trades are profitable. When that happens, trade aggressively and trade larger. We must make our proverbial "hay" when the sun does shine. 15. When adding to a trade, add only 1/4 to 1/2 as much as currently held. That is, if you are holding 400 shares of a stock, at the next point at which to add, add no more than 100 or 200 shares. That moves the average price of your holdings less than half of the distance moved, thus allowing you to sit through 50% corrections without touching your average price. 16. Think like a guerrilla warrior. We wish to fight on the side of the market that is winning, not wasting our time and capital on futile efforts to gain fame by buying the lows or selling the highs of some market movement. Our duty is to earn profits by fighting alongside the winning forces. If neither side is winning, then we don't need to fight at all. 17. Markets form their tops in violence; markets form their lows in quiet conditions. 18. The final 10% of the time of a bull run will usually encompass 50% or more of the price movement. Thus, the first 50% of the price movement will take 90% of the time and will require the most backing and filling and will be far more difficult to trade than the last 50%.

There is no "genius" in these rules. They are common sense and nothing else, but as Voltaire said, "Common sense is uncommon." Trading is a common-sense business. When we trade contrary to common sense, we will lose. Perhaps not always, but enormously and eventually. Trade simply. Avoid complex methodologies concerning obscure technical systems and trade according to the major trends only.

Written by Richard Rhodes

http://www.stockcharts.com/education/What/TradingStrategies/TradingRules-print.html (3 of 4) [2/18/2003 5:31:46 AM]

StockCharts.com - Richard Rhodes' Trading Rules

Send us your Feedback!

©2002 StockCharts.com All Rights Reserved Terms of Use

http://www.stockcharts.com/education/What/TradingStrategies/TradingRules-print.html (4 of 4) [2/18/2003 5:31:46 AM]