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Technical Analysis I: Charting Tools

Fundamental analysis gives the investor information on company performance. This is not the only determinant of the market price of companies. If fundamental analysis explained the market price behaviour of the company fully, then all investors would be able to quote a single price for the company. Besides this fundamental information, the market price may also be influenced by other psychological factors such as perception, sentiment and so on, of investors. The proxy for the measure of this psychological factor is the past share price of the company itself. A study of past share price behaviour to predict the future trend is termed as technical analysis. Depending only on technical analysis to make an investment decision brands that investor as a chartist or technical analyst. Technical analysis is also frequently used as a supplement to fundamental analysis. Technical analysis is based on the economic premise that forces of demand and supply determine the pattern of market price and the volume of trading in a share. The greater the demand for a company’s share, the higher its market price. The greater the supply of a company’s share in the market, the lower the market price. The triggers for this demand and supply could also be the fundamental news on the company. Technical analysis hopes to capture a price trend from the previous traded prices and uses this trend to make an investment decision.

It has been observed that human nature remains more or less constant and tends to react to similar situations in consistent ways. Based on this premise, by studying the nature of previous market turning points, it is possible to develop some characteristics that can help identify major market tops and bottoms. The technical approach to investment is essentially a reflection of the idea that prices move in trends that are determined by the changing attitudes of investors towards a variety of economic, monetary, political, and psychological forces.

Since technical analysis has a huge quantum of information in terms of intra-day traded prices and opening/closing day prices, the data is represented mostly in terms of charts. Charts plot the price information well and several observations have been made from the formation of similar patterns over a period of time.

CHARTS

Charts have the strength of condensing information into a pattern that is easy to understand and grasp rather than numbers or statements. Chart patterns put all buying and selling that takes place in the capital market into perspective by consolidating the forces of supply and demand into an overall picture. As a complete pictorial record of all trading, chart patterns provide a framework to analyse the position of the market in terms of a single share or a consolidation of the market position. More importantly, chart patterns and, hence, technical analysis can help determine who is dominating the market at a specific time. This information can help investors to understand the market and achieve their investment goal.

Chart pattern analysis can be used to make short term or long term forecasts. The data can be intra-day, daily, weekly, or monthly and the patterns can be as short as one day or as long as many years. Certain trading patterns could be identified through the plot of intra-day prices itself, while many patterns take months of trading data to form.

Charts can be plotted using arithmetic or logarithmic price scales. For some types of analysis, particularly for very long range trend analysis, there may be some advantage in using logarithmic charts. On the arithmetic scale, the vertical scale (price) shows an equal distance for each price unit of change. On the log scale, however, the percentage increases get smaller as the price scale increases. For example, a move from 5 to 10 on an arithmetic scale would be the same as a move from 50 to 55, even though the former represents a doubling in price, while the latter is a price increase of only 10 per cent. Prices plotted on ratio or log scales show equal distances for similar percentage moves. For example, a move from 10 to 20 would be the same distance on a log chart as a move from 20 to 40 or 40 to 80.

The most commonly used charts are:

1. Line Charts/Line and Volume Charts
2. Bar Charts
3. Point-and-Figure Charts
4. Candle Stick Charts

A brief comparison of these four types of charts is given below.

1. Line chart
   

   The line chart connects the prices over a time period and is more useful for identifying long-term trends. It has a line that connects the closing price against time.

2. Bar chart
   

   The bar chart gives the chartist information on price changes at a time. In this, the high, low, open, close share price or index level is plotted against time.

3. Point-and-figure chart
   

   The point-and-figure chart shows only the price changes. It eliminates noise of detail, focusing only on trends. The two distinct marks of cross/round indicate respectively a rise/fall in a price range.

4. Candlestick chart
   

   Candlesticks plot information similar to bar charts but could reveal an extra intuitive interpretation. Candlesticks are shown as a vertical rectangle with wicks at both ends. When the closing price is higher than the opening, the rectangle is transparent, and in the reverse case, it is black.

Two basic tenets of technical analysis are that prices exhibit trends and history repeat themselves. An up trend (bullish market) indicates that the forces of demand (bulls) are in control, leading to an increase in the share prices, and a downtrend (bearish market) indicates that the forces of supply (bears) are in control, causing a decline in the share prices. However, prices do not trend forever and as the market forces change, a chart pattern begins to emerge. These patterns can help investors to predict the bullish or bearish position of the market. Certain patterns might not necessarily be followed constantly by a specific market trend; they are the uncertain indicators, during which time the investor ought to depend on other forms of market analysis in addition to the charts.

Knowing where certain patterns are most likely to occur within the prevailing trend is one of the key factors in being able to recognise a chart pattern. This brings subjectivity into the recognition of patterns by a chartist. Observations of prices over a period of time have indicated certain unique patterns that lead to consistent future price movements. Chartists are on the lookout for the formation of such patterns in prices, so that the market player can take the desired investment position. A vast majority of chart patterns may be divided into two main groups: reversal and continuation. Reversal patterns indicate a change in the previous trend occurring in the market. Continuation patterns confirm the movement of market in the same direction as the previous trend. Both these help the chartist to predict a bullish or bearish market movement. A few examples of the reversal and continuation patterns are given in Table 12.1.

 

Table 12.1 Reversal and Continuation Patterns

Reversal Patterns	Continuation Patterns
Head and Shoulders	Symmetrical Triangles
Inverse Head and Shoulders	Ascending Triangles
Triple Tops	Descending Triangles
Triple Bottoms	Flags
Double Tops	Pennants
Double Bottoms	Gaps

Reversal Patterns

Reversal patterns indicate that an important reversal in trend is taking place. Examples of these are the head and shoulder formations, double tops and bottoms, saucer formations, and so on. There are a few important points to be considered, which are common to all of these reversal patterns.

1. The existence of a prior major trend is an important prerequisite for any reversal pattern. If a price pattern has not been preceded by an existing trend, there is nothing to reverse and the pattern would therefore be misleading. Knowing where chart patterns are most likely to occur within a price trend is one of the key factors in identifying price patterns.
2. The indicator of an impending trend reversal is often the breaking of a major trend line. The breaking of a major trend line signals a change in trend. This has to be interpreted cautiously. The breaking of an up trend line might signal the beginning of a sideways trend that may later form either to be a reversal or continuation pattern.
3. The larger the pattern the greater is the price movement potential. The height of the pattern could confirm the volatility. The width of the pattern measures the amount of time required to complete the trend. The greater the height of the pattern (the volatility) and the longer it takes to complete, the more important the pattern becomes for the investor.
4. Bearish patterns are usually shorter in duration and more volatile than bullish patterns. For this reason it is usually less risky to identify and trade bottoms than tops. Therefore, an investor would benefit by entering the market in a downswing rather than the upside of the market.
5. Volume generally increases in the direction of the market trend and is an important confirming factor in the completion of all price patterns. The completion of each pattern should be accompanied by a noticeable increase in volume, particularly at market bottoms. Market tops tend to fall even without considerable volume once a trend reversal sets in. At a market bottom, if the volume pattern does not show a significant increase following the upside breakout, the entire price pattern may not be meaningful to the investor.

Continuation Patterns

The second group of chart pattern is the continuation pattern. Continuation patterns suggest that the market is only pausing for a while before the prevailing trend resumes. A continuation pattern implies that the previous trend will resume when the pattern is complete. Another difference between reversal and continuation patterns is their time duration. Reversal patterns usually take much longer to form on the chart and represent major changes in trend. Continuation patterns, on the other hand, are usually shorter in duration and are often classified as intermediate term chart patterns. Some of the most common continuation patterns include flags, ascending and descending triangles, symmetrical triangles, pennants, gaps, and rectangles.

After rapid price movement, markets tend to absorb the instability generated by that trend’s momentum. This is the consolidation period of the market. During this consolidation period, the new price level undergoes continuous testing for support and resistance. To the technical analyst these are the continuation patterns with familiar shapes of flags, pennants, and rectangles.

When examining continuation patterns, the chartist pays close attention to proportionality. This visual examination will validate or nullify all other predictive observations. Narrowed ranges should be proportional in both time and size to the trends that precede them. When they take on dimensions larger than expected from visual examination, the observed range actually could indicate the next trend.

All patterns must be evaluated within the context of this trend relativity. The existence of any range depends upon the time frame being considered. For example, a market may show a strong bull move on the weekly chart, a bear on the daily, and a continuation pattern on the 15-minute chart, all for the same time duration.

LINE CHARTS/LINE AND VOLUME CHARTS

The line charts usually plot the daily closing price of a share. A line joins these plots. Hence the name line charts. When the share is not traded on a day, the chart displays a gap in the line. The chapter query chart is an illustration of a line chart. The line and volume chart displays the volume of traded shares on a separate scale below the line chart. The line and volume chart for Reliance Industries is shown in Figure 12.2.

The belief in technical analysis as an investment decision tool is because of specific patterns emerging out of such plots. A study of past prices of several companies over a decade has enabled chartists to look for such specific patterns and predict the future behaviour of share prices. The market price is information by itself and reflects the expectations of investors in the capital market. Hence, chartists look for significant movements in share prices and foresee investor expectations from such movements. The changing of expectations often causes price patterns to emerge. Although no two markets are identical, their price patterns are often very similar. Predictable price behaviour often follows these price patterns. Patterns such as flags, triangles, head and shoulders, and so on, are identified using a plot of the price along with the volume of traded shares.

Chart patterns can last from a few days to many months or even years. Under the broad group classification of reversals and continuation patterns, a chartist can further categorise the reversals into those leading to a bullish or bearish market. The appearances of uncertain patterns predict investor dilemmas. Generally, indecision or a lack of enthusiasm results in price patterns that interrupt the trend in prices for a short period. When patterns mature through the passage of time, there is often a resolution, through either a continuation of the trend or a trend reversal. Traders often look for such evidence in price and volume when determining whether a breakout from a consolidating pattern will support a continuation of the trend that leads into the pattern or whether a reversal of the trend will occur. Patterns, hence, could be bullish or bearish indicators. In capital markets, a price rise is referred as a bullish time and a price fall is termed as bearish time.

REVERSAL PATTERNS

Bullish Indicators

Price rise follows certain patterns of share prices charts. The most recognised bullish patterns are the inverted head and shoulders, the saucer, double bottom, triple bottom, cup and handle breakdown, and falling wedge.

Inverted Head and Shoulders

A neckline identifies the inverted head and shoulders. A break in the neckline indicates the reversal and the bullish run can be identified. Inverse head and shoulders occur at market bottoms. From the Castrol example (Figure 12.3), we can spot the inverted head and shoulders position. Point ‘A’, is a peak point, above which we have points ‘B’ and ‘C’. The share price had reached a low of 232 followed by a new low of 193 and again had recovered at 235. This pattern of recovery is an indicator that in future the share price will face a bullish run. Point ‘D’ shows the bullish push of the share price to 318.

Saucer

Rounding bottoms occur as expectations gradually shift from bearish to bullish. The share price of ACC is a typical illustration of saucer formations indicating shifts of bearish and bullish runs (Figure 12.4). The areas ‘A’ and ‘C’ indicate rounded bottoms. The areas ‘B’ and ‘D’ that follow these rounded bottoms indicate the bullish rise in the price of ACC shares.

Volume during both rounding tops and rounding bottoms often mirrors the bowl-like shape of prices during a rounding bottom. Volume, which was high during the previous trend, decreases as expectations shift and traders become indecisive. Volume then increases as the new trend is established. ACC’s volume of trading (Figure 12.5) also reflects the bowl-like shape during the two saucer formations. The higher price is backed by higher volume during the months December to January.

Double Bottom

A double bottom also indicates a bullish trend in the prices. A double bottom occurrence can also follow a down trend. At the end of the downtrend, a double bottom could indicate a reversal in pattern. A double bottom indicates that a price level is visited twice before it breaks up into a bullish pattern. Double bottom indicates a broader base, which helps in the upswing movement of prices, like the saucer.

The double bottom occurs when a share hits a low after a sizable move, pulls back but fails to hit the old low. A variation of the double bottom is the 1–2-3-chart pattern. The 1 is a recent old low with a failure to breach the immediately prior low, 2 is a move up again, which breaks the downtrend. Finally, 3 is where the stock price rises above the channel created by the first low and bounces up. The 1–2-3-chart pattern is shown in the price movement of Bajaj Auto shares (Figure 12.6). If the 1–2-3 is accompanied by a big increase in volume it is normally a sign for a resistance. The volume outbreak in February indicates the resistance to low price and indicates a bullish run for the share.

Triple Bottom

Similar to the double bottoms, triple bottoms also foresee a bullish trend in the market. Triple bottoms indicate a prolonged market situation. A triple bottom formation may evolve in the long range. The triple bottom does not show a recovery in prices over a period of time. It reiterates the slump in the prices and a break in the formation occurs when the volume increases above the average. The share price of Mahindra and Mahindra (Figure 12.7) illustrates the triple bottom. The triple bottom differs from the inverted head and shoulders slightly since the neckline that can be identified clearly in the inverted head and shoulders formation is not present in the triple bottom. The points ‘A’, ‘B’, and ‘C’ plot the triple bottoms in the graph. The breakout occurs confirming the reversal pattern leading to a bullish run in the shares. The triple bottom signals the end of the down trend. All the low prices tend to indicate a resistance level and helps in pushing the price to a bullish run in the market.

A bounce back from a triple bottom is a buy signal. Risk involved at this market timing is low. Risk is small because one can enter into a short position if the share price turns back to the bottom. Short position is to sell the share without holding it. Once the price comes down, the share is bought to settle the short sales made earlier.

Up Trend

An up trend is defined as a series of successively higher peaks and troughs. The troughs are called support. It indicates a level or area on the chart indicating the market situation where buying activity of investors is sufficiently strong to overcome selling pressure. As a result, a decline is halted and prices turn back up again. Usually a support is identified beforehand by a previous low. Resistance is the opposite of support and represents a price level or area over the market where selling pressure overcomes buying pressure and a price advance is turned down. Usually a previous peak identifies a resistance level.

In an up trend, the support and resistance levels show an ascending pattern. The resistance levels represents pauses in that up trend and are usually exceeded at some point. For an up trend to continue, each successive low must be higher than the one preceding it. Each rally high must be higher than the one before it. If the corrective dip in an up trend comes all the way down to the previous low, it may be an early warning that the up trend is ending or at least moving from an up trend to a sideways trend. If the support level is violated, then a trend reversal from up to down is likely.

The line chart for Ranbaxy (Figure 12.8) shows points A, B, C (troughs), the lows that are above each other. This is an up trend. An up trend has the resistance line (AC), which indicates the continuation of the up trend or the bullish run of the prices in the market. A new low achieved below this resistance level would change the up trend pattern. An up trend is thus a series of higher highs and higher lows. An up trend is drawn under the beginning low and the lowest low of an upwards move.

Falling Wedge

The falling wedge is a bullish pattern that begins wide at the top and contracts as prices move lower. This price pattern forms a cone that slopes down as the highs and lows converge. Falling wedges show a persistent slope down and leads to a bullish market. The falling wedge can also lead to continuation pattern. As a continuation pattern, the falling wedge will still slope down, but the slope will be against the prevailing down trend. As a reversal pattern, the falling wedge slopes down, with the prevailing trend. The share prices of Dena Bank illustrate the falling wedge (Figure 12.9). The falling wedge supported by the volume rise forecasts a bullish trend in the prices. At each stage when the price breaks, the above average volume indicates the rise in prices. The falling wedge has a definite slope where the highs and lows converge at a point. The vertical dotted line indicates the point of convergence. This forecasts the bullish run in the price of shares.

The falling wedge can be one of the most difficult chart patterns to accurately recognise and trade. When lower highs and lower lows form, a share remains in a downtrend. Even though selling pressure may be diminishing, demand does not dominate until resistance is broken. As with most patterns, it is important to wait for a breakout and combine other aspects of technical analysis such as volume to confirm signals.

Cup and Handle Breakdown

In a cup and handle the breakout should be accompanied by strong volume, significantly higher than prior trading. A cup with handle formation will be identified through the following formations; left-hand side formation, right-hand side formation, and bottom formation. Figure 12.10 marks the cup with handle formation for Dalmia Cement Shares in the Bombay Stock Exchange. A horizontal line is drawn at the level of the right-hand side of the cup to show the move towards the bullish phase. The horizontal line can be drawn until either the upward price breakout occurs or the price falls below an acceptable level. The chart indicates an upward price breakout after the cup formation.

The cup and handle formation occurs after a trend change, where a series of rising peaks and troughs is followed by a reversal of the price trend. A downtrend of lower peaks and lower troughs form the left side of the cup, rounds out and later begins a new rising trend so that a cup is formed. The cup is in the shape of a “U”. The handle is a drop in prices after the right side of the cup has been reached. The handle can have a variety of shapes and can consist of double handles.

Volume in the chart is low and peaks at the right side of the cup. Selling pressure is typically present as those investors who bought the share as the left side peak occurred, sell at the rising trend of the right side of the cup and this often leads to the formation of the handle. When the enthusiasm of selling during the formation of the handle continues, there is evidence of the resulting trend, after the handle is fully formed. Low selling during the handle formation leads to a greater potential for higher prices, after the cup and handle formation is complete.

The cup and handle formation is uncommon and forms over various time spans. The resulting market activity should never be taken for granted, as there is much more insight in the psychological settings, economic trends and fundamentals that produce such price action in the market.

Bearish Indicators

Among the most commonly encountered bearish patterns are the head and shoulders, the double top, the triple and round top, the downtrend and the inverted version of the bullish saucer.

Head and Shoulder

The head and shoulders price pattern is the most reliable and well known chart pattern. It gets its name from the resemblance of a head with two shoulders on either side. An up trend is formed as prices make higher highs and higher lows in this step movement. The trend is broken when this upward climb ends. The head formation, which is above the left and right tops, distinguishes this formation. The left shoulder and the head are the last two higher highs. The right shoulder is created as the bulls try to push prices higher, but are unable to do so. This signifies the end of the up trend. Confirmation of a new down trend occurs when the neckline is broken.

During an up trend, volume should increase during each rally. A sign that the trend is weakening occurs when the volume accompanying a rally is lesser than the volume accompanying the preceding rally. In a typical head-and-shoulders pattern, volume decreases on the head and is especially low on the right shoulder.

Following the break of the neckline, it is very common for prices to return to the neckline in a last effort to continue the up trend. If prices are then unable to rise above the neckline, they usually decline rapidly.

The line/volume chart of Glaxo (Figure 12.11) shows points ‘A’, ‘B’, and ‘C’, the respective left shoulder, head, and right shoulder points. The volume loss is seen from the volume bars, but the volume has not recovered much. The point ‘D’ indicates the price level to which the share has been pushed down in the bearish run.

Double Top

This occurs when a share hits a high or a low after a sizable move, pulls back but fails to hit the old high. There is a price rise with a failure to break the immediately prior high. Then, there is a move down, which again breaks the up trend. Finally, the share price falls below the line created by the second move and falls down.

Figure 12.12 shows a line chart with a double top. This arises when the share price has risen sharply, followed by a limited profit taking, which causes the share price to fall. The share then rallies around the previous high figure but again meets resistance. Investors decide that the peak has been reached and they take their profits, causing the price to fall again. The neckline is the support level above which the pattern forms. Any breakout through the neckline indicates a reversal. If the price falls below the neckline the shares should be sold; if it rises above, then they should be purchased.

Triple Top

Triple top patterns, which appear frequently in trading, are relatively easier to detect. Figures 12.13 and 12.14 show some typical triple top patterns. The share prices of ITC (Figure 12.13) and Cinevistaas (Figure 12.14) illustrate the triple tops. The points ‘A’, ‘B’ and ‘C’ indicate the tops, and ‘D’ shows the bearish trend in the prices. In Cinevistaas, the point ‘E’ indicates the bounce back of share price from the bearish trend, which is a sell signal to investors.

Inverted Saucer

An inverted saucer is formed when there is a rounded top formation. The prolonged rise in prices will break out into a bearish run since it had rallied on to the same price level for a longer duration. The Hindalco shares have a rounded top (inverted saucer) formation (Figure 12.15) that has led to the bearish pull of the share prices from Rs 860 to Rs 510.

Down Trend

A down trend is just the opposite of an inverted saucer, a series of declining peaks and troughs; the support and resistance levels are also in descent. In a down trend, support levels are not sufficient to stop the decline permanently, but are only able to check it temporarily. A down trend is a series of lower highs and lower lows. A down trend line is drawn from the initial high to the next highest high of the downtrend (Figure 12.16).

Rising Wedge

The rising wedge is a bearish pattern that has a wide bottom and contracts as prices move higher and the trading range narrows. Rising wedges slope up and indicate a bearish forecast (Figure 12.17).

This pattern can also be a continuation pattern. As a continuation pattern, the rising wedge will still slope up, but the slope will be against the prevailing uptrend. As a reversal pattern, the rising wedge will slope up, along with the prevailing trend.

The rising wedge also like the falling wedge can be one of the most difficult chart patterns to accurately forecast prices. 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 been established and lower prices are likely.

CONTINUATION PATTERNS

Triangles, flags, gaps, and pennants can be categorised as continuation patterns. They usually represent only brief pauses in a dynamic market. They are typically seen right after a big, quick move. The market then usually takes off again in the same direction. Though research has shown that these patterns are reliable they may initially appear to be continuation patterns and may end up being reversal patterns.

Triangles

Triangles are sideways trading actions, with the widest part of the correction occurring earliest in the development of the pattern. As the market continues in its sideways or horizontal pattern, the trading ranges narrow, forming the shape of a triangle. Triangles appear in the following forms: ascending, descending, symmetrical, and expanding triangles. In the formation of a triangle, there are two trend lines. The upper trend line, referred to as the supply line, represents resistance. The supply line represents a lack of conviction by the buyers to commit more funds to the market in a particular share, because of which there is profit-taking and short selling to turn prices back down. The lower trend line is the demand line and represents support. In this situation, it is the buyers who bounce back and drive the prices upwards again.

There must be at least four reversal points in order for a triangle to be recognised and one may also see as many as six reversal points (three peaks and three troughs). There is a time limit for the resolution of the pattern, and that is the point where the two lines meet. As a general rule, prices should break out in the direction of the prior trend, after the triangle. Because the two lines must meet at some point, the time distance can be measured once the two converging lines are drawn. An upside breakout is signaled by a penetration of the upper trend line. If the prices remain within the triangle beyond the convergence, the triangle is a misleading pattern. Here, the prices will continue to drift down indicating a reversal.

Figure 12.18 shows Creative Eye’s daily prices and a very clear symmetrical triangle. In the first week of October, the market formed an isolated high. The market declined and formed an isolated low during the second week. Then, the market advanced and formed the second isolated high in the third week of October. The upper sloping line indicates the supply line. After a few days, the market reached the next isolated low, and here the lower sloping line drawn indicates the demand line. At this point, the triangle can be identified and can expect a continuation of the previous trend that is the bullish phase of the share price. Prediction failures by continuation patterns can forewarn a more substantial market correction and a reversal.

The ascending triangle (Figure 12.19) is particularly significant because it forms less frequently than the other, descending or symmetrical, triangle patterns, and is more likely to be signalling an upward movement in the security.

As an ascending triangle formation occurs, it usually signals a continuation pattern in an up trend, but can sometimes be found at the bottom of a downtrend, signalling a reversal. The ascending triangle has a flat upper trend line while the lower trend line slopes upward. This is indicative of more aggressive buying than selling as the lows get progressively higher, while the highs are at the same level each time before breaking out to the upside.

The completion of the formation occurs when prices break through the upper, flat trend line, before convergence of the triangle. Prices could retrace to the horizontal trend line before resuming their upward path, but do not re-enter the triangle.

Typically, volume is heavy at the beginning and reduces during the formation of an ascending triangle. It again increases during the breakout above the flat trend line. This occurs, as buyers push the share up and try to enter the market.

The descending triangle can signal the reversal of an up trend in the market. It is formed when a bull run in a share’s price levels off and is followed by a series of lower highs and relatively equal lows. Figure 12.20 illustrates a descending triangle pattern. A trend line connecting the descending peaks, and another line connecting the troughs have been drawn in the chart. These lines were extended to the right until they formed a descending triangle. Volume, that was typically heavier at the beginning of the pattern, decreases as price moves towards the convergence and then increases during the breakout.

The minimum number of lows and highs required to form the descending triangle, or any triangle for that matter, is two of each, for a total of four. The descending triangle is referred to as a right-angle triangle because if a vertical line is drawn at the open end of the triangle, a right-angle triangle could be formed. If this pattern were followed by a breakout to the downside from within the triangle formation, it would confirm the continuation pattern.

The successive lower highs forming the descending side of the triangle indicates more aggressive selling than buying. Frequently, prices will break out to the downside after a number of reversals (minimum of four) within the bounds of the two trend lines.

The expanding triangle will have the smallest area on the left of the chart and prices expanding to the right. It will have higher highs and lowers lows occurring as the share price expands into the pattern.

An expanding triangle is actually rare in financial markets. Figure 12.21 shows the Elbee Service price movement. Each swing becomes larger than the first and comes on a bounce back. Each movement thus, forms a higher high and a lower low before the market continues with the previous market trend.

It is not uncommon for prices to retrace back to the trend line after breaking out of the triangle and then reverse again, continuing in the direction of the breakout. The breakout is considered to have failed if prices move significantly back into the triangle pattern, which might happen occasionally.

Finally, triangles can be used to identify consolidation periods for strong market leaders that are in well defined up trends; by watching how triangles or other continuation patterns are unfolding.

Once triangles are properly identified, subsequent price tends to react in predictable ways. In most instances, after prices break out of the triangle pattern, it is highly probable that prices will continue moving in that direction. Knowing this gives the investor the opportunity to trade in that direction, with confidence.

The Flag

A flag is defined as a parallelogram and forecasts the current trend. In almost all cases, flags show the chartist a very short pause in the trading activity of the prevailing trend. Flags usually last only a few weeks. A key to the recognition of flags is that the volume will diminish dramatically.

The flagpole, a sharp increase or decrease in price action during one trading day is a prominant formation in the flag. This is followed by the flag pattern creating lower ‘lows’ and lower ‘highs’ until the next major move in the prevailing trend (Figure 12.22). As the flag is developed, it will result in a fall or rise in price compensating what the flagpole acquired on one day by a sharp increase or decrease.

With respect to flags in a down trending market, the time it takes to form will be very short, as investors tend to sell in panic.

Lower tops and lower bottoms characterise bullish flags, with the pattern slanting against the trend. But unlike wedges, their trend line runs parallel. Bull flag in an up trend is illustrated in the Emco share chart (Figure 12.23). The dashed parallel lines characterise the flag. The flagpole identifies the unique flag pattern. The volume accompanied by the flag pattern is very small, but the breakout in the pattern is characterised by large volume. Also, the breakout price from the flag pattern is as large as the flag’s pole.

Bearish flags are comprised of higher tops and higher bottoms. Bear flags also have a tendency to slope against the trend. Their trend line runs parallel as well. Bearish flags are formed with declining volume to imply that the rise is bearish in nature. When the price breaks out, the sharp slide continues.

Sonata Software (Figure 12.24) breaks down strongly to a price of 12, with large volume, right after opening at 18. This part forms the pole of the inverted bearish flag. Then it temporarily rises back to 14.7, a level still lower than the pre-break level of 15.9. The investment strategy here has to be to sell the share near this level, ie, 15 and hope to buy it back at 12 or lower.

The bearish flag trading pattern is just the opposite of the bullish flag. In the Sonata Software line chart, the share price is in a general down trend, breaking down with large volume on February 16. Then, it bounces back to a level still a bit lower than the low of the pre-breakout range. Investors, if they missed the opportunity to short sell the share after the flag formation could attempt to sell the share on February 20. If the share price, instead of going down, rises above the low of the pre-breakout range, the investor must buy the share back immediately to cover the loss.

Pennants

Pennants are typically smaller in size (volatility) and duration than triangles. The pennant is also a brief period of consolidation in prices in a trend. Once the consolidation is over, the price moves in the same direction of the previous trend. The move following a breakout from a pennant is expected to be about the same as the move up or down immediately before the pattern formed. The bullish and bearish indicators of pennants are given in Figure 12.25.

Bullish pennants are very similar to bull flags. The difference is the triangular consolidation after the flagpole (pennant shaped), as opposed to parallel consolidation in flags. Like flags, pennants also indicate continuation of prior trend because they almost always lead to large and predictable price moves. Pennants usually take shape at the mid point of a major move. The first part of the pennant pattern is often called the flagpole. During this phase the share price a high. Most often this could be the time of unveiling of a new product, a favourable legal resolution, or a positive earnings report, and so on. As the share price soars, speculators who would have purchased the share at lower levels begin selling. At this point the second phase or pennant portion of the pattern begins. Because the flow of news and investor sentiment is positive, most of the share sold by speculators is easily absorbed in the beginning, but as time passes fewer investors seem willing to pay the current price. Slowly, the share price begins to fall down with reduced volume. This attracts buyers, pushing the share very near the most recent high, but because volume is low this rally is not sustained for long and a slightly lower high is established before the price turns lower. The new round of selling sends the share price lower on reduced volume. After several more consolidations, the share price confirms a bullish continuation pattern. This results in a pennant formation.

The bullish pennant in Crest Communications is shown in Figure 12.26. Bullish pennants involve two distinct parts, a high volume flag pole (vertical arrow line) and a, low volume triangular consolidation comprising of four points (a, b, c, d), and an upside breakout (point e).

The triangular consolidation during the formation of the pennant implies that traders feel comfortable with the current price. Most bullish pennant patterns occur at the middle of the larger move. If the share closes below the support level (bd), the pattern may not lead to a upswing in prices.

Bearish pennants are similar to bear flags and here also the only major difference is that the consolidation after the flagpole is triangular (pennant shaped) as opposed to being parallel (flag shaped). The first part of the bearish pennant pattern is called the flagpole. During this phase the share price falls to a low following some negative fundamental development. As can be seen from Ashok Leyland Finance Company’s share (Figure 12.27), this will lead to a downward slope of the share price, an unfavourable worker’s strike, and a negative earnings report. But the change in price is near vertical as would-be buyers are smaller than the frantic sellers. As the share collapses some speculators who have made short sales at higher levels begin buying to cover their short positions (a). At this point the second phase or pennant portion of the bearish pennant begins. Because the flow of news and investor sentiment is negative, the consolidation phase might end in a top price with low volume (b). This rally may continue for a while (c) and (d) before the market confirms the bearish pattern (e).

Gaps

Gaps are best detected in a bar chart or a candlestick chart. They occur when the lowest price traded is above the high of the previous day or, conversely, when the highest price traded is below the previous day’s low. A gap is filled when the range of subsequent prices closes the gap. Gaps can be common gaps, breakaway gaps, continuation gaps, and exhaustion gaps. They are discussed in detail in bar charts.

Rectangle

The rectangle is a chart pattern (Figure 12.28) in which the price of a share bounces back and forth between two horizontal lines. Because a rectangle is thought to occur when a share is being bought or sold by investors in a market without any new information.

The rectangle appears less often but is a more reliable continuation pattern predictor. It lasts until the share price breaks through either its bottom line—representing support—or its top line—representing resistance. The volumes during the rectangle formation pattern is low but there is a clear increase on the breakout.

Rectangles are sometimes referred to as trading ranges or consolidation zones. 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, sellers force the price lower. Speculators sometimes play these bounces by buying near support and selling near resistance. Such types of market consolidations that prevail for a long duration may either result in a continuation pattern or a reversal. Only until the price breaks above resistance or below support will it be clear as to the emerging pattern is a continuation or a reversal.

Horizontal Peaks and Troughs

Horizontal peaks and troughs identify a sideways price trend. A sideways trend is a series of horizontal peaks and troughs, with prices moving within a range, failing to make new highs at the top of the price range and failing to make new lows at the bottom of the price range. The horizontal peaks and troughs are usually traced inside a rectangle or square formation.

Frequent trading at times when the market is experiencing such horizontal price movements would result only in high transaction costs (loss) to the speculator. Hence, during these times, when the market is moving sideways, to stay out of the market becomes the best strategy for the frequent trader.

BAR CHART

The bar chart is also commonly used by technical analysts. The horizontal scale on the bottom of the chart indicates time. The time scale can be daily, weekly or monthly depending on trading frequency in the market. The daily bar chart indicates the range of prices for one day’s trade, on the vertical scale of the chart. The bar is the range of price for a specific time period. For a daily bar chart, the top of the bar represents the highest value for the day while the bottom of the bar represents the lowest value for the day. Attached to the bar are two tics, one extending to the left and one extending to the right. The left tic represents the opening price for the day and the right tic represents the closing price for the day. These are referred as OHLC. See Figure 12.29.

OHLC typically stands for the price category displayed on a price bar:

• Opening price; (O)
• Highest price; (H)
• Lowest price; (L) and
• Closing price (C).

This chart has more information content since it shows the high and low, open and close position together in a chart. Figure 12.30 shows a bar chart of the common head and shoulder formation. This formation develops when a share price rises quite quickly, falls back because of profit taking (the left shoulder), rises again sharply to a new high (the head), falls again due to profit taking, rallies again (the right shoulder), and then falls because of profit taking. Once the right shoulder has been reached the share price drops quickly, and once it falls below the neckline this is a signal to investors to sell the share.

The daily bar chart could be used for short term investment decisions, and is extremely useful for timing entry and exit points.

In the weekly chart the price range is for one week, Monday to Friday. If a holiday occurs during the week only the data available for that week is used. The top of the bar represents the highest value for the week and the bottom of the bar represents the lowest value for the week. The tic to the left is the opening price for the first trading day of the week, usually Monday, and the tic to the right is the closing price at the close of trade on Friday.

Similarly the monthly chart includes the range of trade for an entire month, from the first trading day of the month to the last trading day of the month, while also considering the high and low prices for the month.

The weekly and monthly charts are used for a long term perspective of markets, and are extremely useful for investment decisions. For instance, if market prices, as indicated on the monthly chart, are at historical lows, sale of shares should be delayed, while if prices were historically high, a sale should be considered by the investors.

Two other important information can be included on a bar chart ie., Volume and Open Interest.

Volume represents the total amount of trading activity that took place in a share for a period of time. Volume is plotted as a vertical bar extending upward from the bottom of the chart, directly under the price bar for that period, as in the line chart.

Open interest represents the total number of outstanding shares at the end of a trading day. It can also be restated as the total of either the outstanding purchases or sales.

Open interest is plotted as a line above the volume bars on the price chart, with a vertical scale indicating the total number of shares outstanding. A bar chart with volume and open interest is shown in Figure 12.31.

Interpreting High/Low Positions in Bar Charts

In bar charts, an up trend is a series of bars with higher highs and higher lows. A down trend is a series of bars with lower highs and lower lows. A bar chart starts an up trend with a higher high and higher low than the previous bar (Figure 12.32). Conversely, a bar chart starts a down trend with a lower high and lower low than the previous bar.

Often trends are not very clear when there is uncertainty among buyers and sellers. Inside days, outside days, and borderline days are signs of uncertainty in a trend (Figure 12.33). Inside days have a lower high and a higher low when compared to the preceding bar. Outside days have both a higher high and a lower low than the previous day. Borderline days are similar to inside or outside days, but there is an equal high or equal low.

Interpreting Bar Ranges

The range is the distance between the high and the low on a bar. Expanding ranges is an up trend signal, indicating increasing dominance from buyers; and in a downtrend, increasing dominance from sellers. Contracting ranges show decreasing dominance. See Figure 12.34.

Interpreting Close/Open Positions

Buyers are dominant when the present closing price is higher than the previous closing price. Conversely, a sellers market will be indicated by a current close lower than the previous close.

The dominance of buyers and sellers is also indicated by the position of the closing price in relation to the close on the preceding bar. See Figure 12.35. The larger the distance, the greater the dominance. The position of closing price on the bar indicates who controls the market at the end of the day, and their level of commitment.

• Closing price at the top of the bar signals that buyers control the market.
• Closing price at the bottom of the bar indicates that sellers have control.
• If both buyers and sellers are equally dominant then closing price is likely to be in the middle of the range.

The daily opening price tends to reflect the view of smaller buyers and sellers. It is useful as an indicator of the emotional direction that the market is likely to take.

• Opening price at the bottom of the range indicates that buyers control the market.
• Opening price at the top of the range indicates that sellers have control.
• Opening price in the middle of the bar indicates that neither has control.

The technical indicators identified while using line charts can also be interpreted using bar charts. Graphical representations of these trend formations, using bar charts, are given in Figure 12.36 and Figure 12.37.

Tracing Gaps through Bar Charts

Gaps form when trading does not take place in the market. Gaps are especially significant forecast tools when accompanied by an increase in volume.

An up gap forms when a share opens above the previous period’s high, remains above the previous high for the entire period and closes above it. Up gaps can form on daily, weekly, or monthly charts and are generally considered bullish.

A down gap forms when a share opens below the previous period’s low, remains below the previous low for the entire period and closes below it. Down gaps are generally considered bearish.

Common gaps occur in markets without a strong trend. They are not followed by new highs or new lows and are quickly closed in the subsequent days’ trading. These gaps do not signify the beginning or continuation of a trend but might represent market anomalies. For instance, if a share has declined 20 significantly in a week and gaps form after this decline, it would be considered a common gap and is not likely to signify a change in trend. Or, if a trading range develops moderately, and gap forms in the middle, it could also be a common gap.

Some common gaps are caused by events and hence should be ignored. They are:

• Ex-dividend gaps, which occur as price adjusts on the day after a dividend becomes payable; and
• New share issues.

The significant trading indicators are breakaway gaps, continuation or running gaps, and exhaustion gaps (Figure 12.38). Breakaway gaps are normally accompanied by heavy volume and occur when prices break out of a trading range. They are usually followed by a series of new highs in an upside breakout or a series of new lows in a downside breakout, and are seldom closed. In an upside breakaway, if the gap is accompanied by heavy volume, the share prices are likely to rise up further. In a downside breakaway, if the gap is accompanied by heavy volume, then prices are likely to go down further.

A running gap forms in the middle of a move and is in the same direction as the current move. These gaps signal a continuation of the preceding trend. After a short or intermediate advance, a continuation up gap is usually considered bullish and signals a renewal of the up trend. After a short or intermediate decline, a continuation down gap is usually considered bearish and signals a renewal of the downtrend.

New highs in an up trend or new lows in a down trend usually follow the running gaps. These gaps are not normally closed.

After a long trade, a gap in the direction of the current trend is called an exhaustion gap (Figure 12.38). In an exhaustion gap prices reverse soon after the gap and close the gap. After an extended decline, a gap down could signal that the down trend is about to exhaust itself. A reversal will follow this exhaustion. Such market movements are called closing the gap. After an extended uptrend, an exhaustion gap would be confirmed when prices reverse soon afterwards and move below the gap. Exhaustion gaps to confirm the reversal will show a heavy volume at the reversal time.

Exhaustion gaps may lead to the formation of island clusters, identified by an exhaustion gap followed (after a few days) by a similar gap in the opposite direction. These are also reversal signals. The island clusters are rounded off in Figure 12.39. Exhaustion gaps, hence, are to be traded very carefully.

CANDLESTICK CHART

Another type of chart is the candle stick chart. In the 1600s, the Japanese developed this method of technical analysis to observe the price of rice contracts. This technique is called candlestick charting.

Candlestick charts can be used to identify price patterns, and are drawn from opening, high, low, and closing data for a specific period such as an hour, day, or week. A candle consists of two parts or vertical extensions, the real body, ie, the rectangle, and the shadow or wick. The top and bottom of the rectangle are determined by the opening and closing prices. If the closing price is above the opening price, the rectangle is white, on the other hand if the closing price is below the opening, the rectangle is blackened. The high and low for the day are the wicks at the top and the bottom of the rectangle.

Each candlestick represents one period (eg, day) data. Figure 12.40 displays the indicators of a candle. The bullish and bearish patterns identified from the candlestick chart formations are discussed below.

Bullish Patterns

Long white (empty) line: This is a bullish pattern. It occurs when prices open near the low and close significantly higher, near the period’s high.

Hammer: A Hammer is bullish, if it occurs after a significant downtrend. It is identified by a small real body (ie, a small range between the open and closing prices) and a long lower shadow (ie, the low is significantly lower than the open, high, and close). The body can be empty or dark.

Piercing line: This is a bullish pattern and the opposite of a dark cloud cover. The previous formation is a long black body and the next formation is a long white body. The current body opens lower than the previous low, but it closes more than halfway above the previous body.

Bullish engulfing lines: This pattern occurs after a significant downtrend. It occurs when a large bullish (empty) body engulfs a small bearish (black) body.

Morning star: This pattern signifies a potential bottom. The star indicates a possible reversal and the bullish (empty) body confirms this. The star follows a black body.

Bullish doji star: A star indicates a reversal and a doji indicates indecision. Thus, this pattern usually indicates a reversal following an indecisive period. The buyer has to wait for a confirmation before trading a doji star. The first body can be empty or black in a doji.

Bearish Patterns

Long black (filled-in) line: This is a bearish line. It occurs when prices open near the high and close significantly lower, near the period’s low.

Hanging Man: These lines are bearish if they occur after a significant up trend. They are identified by small real bodies (ie, a small range between the open and closing prices) and a long lower shadow (ie, the low is significantly lower than the open, high, and close). The bodies can be empty or filled in.

Dark cloud cover: This bearish pattern is more significant if the second black body is below the center of the previous body.

Bearish engulfing lines: This pattern is strongly bearish if it occurs after a significant up trend. It occurs when a large bearish (filled in) body engulfs a small bullish (empty) body.

Evening star: This pattern signifies a potential top. The star indicates a possible reversal and the bearish (black) body confirms this. The star follows an empty body.

Bearish Doji star: A star indicates a reversal and a doji indicates indecision. Thus, this pattern usually indicates a reversal following an indecisive period. This doji star is above the previous body.

Reversal Patterns

Shooting star: This pattern suggests a reversal when it appears after a rally. The star’s body must appear near the low price and the body should have a long upper shadow.

Long-legged doji: This signifies a turning point. It occurs when the open and close are the same, and the range between the high and low is relatively large.

Dragon-fly doji: This line also signifies a turning point. It occurs when the open and close are the same, and the low is significantly lower than the open, high, and closing prices.

Gravestone doji: This line also signifies a turning point. It occurs when the open, close, and low are the same and the high is significantly higher than the open, low, and closing prices.

Star: Stars indicate reversals. A star is a body with a small real body that occurs after a body with a much larger real body, where the real bodies are not the same price range. The shadows may here the same price levels.

Uncertain Patterns

Doji star: A star indicates a reversal and a doji indicates indecision. Thus, this pattern usually indicates a reversal following an indecisive period.

Spinning tops: These are also uncertain indicators. They occur when the distance between the high and low and the distance between the open and close are relatively small.

Doji: This line implies indecision. The share opened and closed at the same price. These lines can appear in other patterns.

Double doji lines: These imply that a significant move will follow a breakout from the current indecision.

Harami: This pattern indicates a decrease in momentum. It occurs when a line with a small body falls within the area of a larger body. Here, a small (black) body follows a bullish (empty) long body. This implies a decrease in bullish momentum.

Harami cross: This pattern also indicates a decrease in momentum. The pattern is similar to a harami, but the small black body is replaced by a doji.

The various candlestick formations are shown in Figure 12.41.

POINT AND FIGURE CHART

The point and figure chart differs from other charts in that there is no time dimension, no volume, but only significant price movement. The purpose of the chart is to record these changes and their direction. Every time the price moves up, this is marked in the same column, at the appropriate price level, by a ‘x’ marking. When there is a fall in price, say, the rising trend falls, then the next column indicates this fall in price with a ‘o’ marking. This type of chart is illustrated in Figure 12.42.

Point and figure chart ignores the time factor and concentrates only on movements in price—a column of X’s or O’s may take one day or several weeks to form. The first X in a new column is plotted one box above the last O in the previous column (and the first O in a new column is plotted one box below the highest X).

The marking X indicates that the price has increased (and O indicates that price has decreased) by one box. A box indicates the minimal quantum of variation in price. Altering the box size can vary the sensitivity of the chart. The box size is the minimum price movement and, hence, helps to eliminate minor price changes. Larger box sizes can also be used for charting longer time periods. The logarithmic scale is useful when plotting substantial price changes, especially over long time periods. Box sizes can be used on normal scale or log scale. Normal scaling is in terms of money either Re1 or Rs 2, Rs 5, Rs 10, etc. In log scaling, box size increases as price increases, enabling us to see the relative changes over a long period of time. Each box size is increased by a fixed percentage of the box below it.

A column of X’s represents a continuous price increase and a column of O’s represents declining prices. A price reversal equal to one box size will result in the formation of a new column. In order to smooth out fluctuations the chart can record price reversals that exceed a set number of boxes. The number of boxes is the reversal amount and a new column will not be started until price has changed by that amount.

In the one box reversal, the reversal amount is the box size. When prices record a downward trend below this box size, a reversal is marked. The reversal amount can be two boxes or three boxes. Sometimes point and figure charts are drawn with as many as ten box reversals. When marking the trend movement over a long duration, the reversal amount would be a larger number of boxes. For instance, in the three box reversal, certain columns that were included in one box reversal will not be marked. Only when prices show a three box change, will they be plotted in the chart. This leads to a condensed trend graph, as shown in Figure 12.43. The effect is columns 5 and 6 (one box reversal) are combined into column 4 in a three box reversal. Columns 8 and 9 (one box reversal) are combined into column 5 in a three box reversal.

 

There are numerous methods of constructing point and figure charts. The earliest method of point and figure charting, introduced by De Villiers in the 1930’s, was a $1 box and a 1 box reversal, which were used to track intra-day price movements. The classic method displays X’s and O’s in separate columns. The High-Low method attempts to better identify bullish and bearish sentiments. Price movements are calculated using the day’s high when prices are rising and the day’s low when prices are falling.

In summary, the three main factors required for point and figure chart presentation are:

1. The price used in the charts: high, low, close, or the average, or any other representation;
2. The reversal amount; and
3. Box size.

Another method of presenting the point and figure chart is to use two prices, the high and low prices for a day. This is the High-Low method of point and figure chart. An illustration using a box size of 1 and a reversal amount of 1 is shown in Figure 12.44 assuming the zero day high and low are both 20.

DAY

1. Since the previous day high and low is 20, compare the high to the last high [20]. If it is not, check for reversal.Compare the low to the last high. If it is lower then a down trend is marked from 19 to 17.
2. Compare the low to the last O [17]. If it is not less than the last low then check for reversal. Compare the high to the last low. If it is not greater by a reversal amount then there is no marking.
3. Compare the low to the last O [17]. If it is less by one box, then draw O at 16.
4. Compare the low to the last O [16]. If is is not less than one box size, then check for reversal. Compare the high to the last O. If it is greater by one box, draw X’s from 17 to 19.
5. Compare the high to the last high [19]. If it is not greater then one box, check for reversal. Compare the low to the last high. If it is lower by at least the reversal amount, (15) than draw O’s from 18 to 15.
6. Compare the low to the last O [15]. If it is not one box low, then check for reversal. Compare the high to the last O. [15] If their is no reveral, then there is no marking.
7. Compare the low to the last O [15]. If it is not less than one box, check for reversal. Compare the high to the last O. If it is greater by at least the reversal amount, draw X’s from 16 to 20.

Most point and figure charts uses end of day data that are not entirely accurate. Price movements during the day may be incorrectly summarised. For example, an intra-day rally will not be recorded if the end of day close is lower than the previous day. It is therefore advisable to minimise distortion from end of day data, by using High-Low method.

Technical Chart Indicators

Plots of the point and figure chart can trace the support and resistance levels, trend lines, breakouts, as well as bullish and bearish market indicators. Support levels are price levels at which large numbers of buyers are expected to enter the market. They are easily identified on point and figure charts by 2 or more columns of O’s bottoming out at the same level. When broken, support levels often become resistance levels. Resistance levels are prices at which large numbers of sellers are expected to enter the market. Resistance levels can be identified when 2 or more columns of X’s end with equal tops. When broken, resistance levels often become future support levels. A column of O’s will always break an up trend, while a column of X’s will first break a down trend. Figure 12.45 shows the point and figure chart technical indicators.

 

The bullish and bearish indicators in the point and figure chart are shown in Figure 12.46.

DOW THEORY

The basic principle of Dow theory is to determine changes in the primary market, and once the trend is established it is assumed to exist until a reversal is proved. Dow theory is concerned with the direction of a trend and has no forecasting value as to the ultimate duration or size of the trend. The basic premise is that the averages discount everything. Changes in daily closing prices reflect the aggregate judgment and emotions of all stock market participants. When charting these closing price changes, the peaks are signals to sell shares and the troughs are signals to buy shares. This is illustrated in Figure 12.47.

 

The Dow theory is based on the writings of Charles Dow over several years. Of the many theorems put forth by Dow, three stand out:

• Price Discounts Every Information.
• Price Movements are not Totally Random.
• Investors can identify facts associated with price movements.

As per the Dow theory, at any given time in the stock market, one of the three forces represents the market movements. These are the Primary trend, Secondary trends, and Minor trends.

The primary trend can either be a bullish (rising) market or a bearish (falling) market. The primary trend usually lasts more than one year and may even last for several years. If the market is making successive higher highs and higher lows the primary trend is up. If the market is making successive lower highs and lower lows, the primary trend is down.

Secondary trends are intermediate, corrective reactions to the primary trend. These reactions typically last from one to three months and retrace from one-third to two-thirds of the previous secondary trend. The line chart of the BSE Sensex in figure 12.47 shows a primary trend (Line “A”) and three secondary trends (“B”, “C”, and “D”).

Minor trends are short term movements lasting from one day to three weeks (“E”, “F”, and “G”). Secondary trends are typically comprised of a number of minor trends. The Dow theory holds that, since share prices over the short term are subject to some degree of price manipulation, minor trends are unimportant and can be misleading.

The Dow theory emphasises more on the primary trend and says that the first phase is made up of aggressive buying by informed investors in anticipation of economic recovery and long term growth. The general feeling among most investors during this phase is a negative feeling of “no recovery” and “frustration” due to the prolonged sluggish prices in the market. Informed investors, realising that a turnaround is inevitable, aggressively buy from these distressed sellers.

The second phase is characterised by company fundamentals, showing through increasing corporate earnings and improved economic conditions. Investors begin to buy shares as conditions improve.

Record corporate earnings and peak economic conditions characterise the third phase. The investors now feel comfortable participating in the stock market. They are almost convinced that the stock market is headed for further upswing. At this time they buy even more shares, creating an unjustified demand. It is during this phase that those few investors who did the aggressive buying during the first phase begin to liquidate their holdings in anticipation of a downturn.

The chart of the BSE Sensex in Figure 12.48 illustrates these three phases during the years leading up to the 1990 stock market crash in India. The first phase ‘A’ is the uncertain phase wherein the market was not sure of the movements. Most expectations were negative, leading to a down trend in the prices. Phase ‘B’ is backed by corporate results. Phase ‘C’ has registered a very sharp acsent in share prices. The sudden drop in 1990 emphasises the undue overvaluations of the market in phase ‘C’.

The Dow Theory focuses primarily on price action. Volume is only used to confirm uncertain situations. Volume is expected to expand in the direction of the primary trend. If the primary trend is down, volume is expected to increase during market declines. If the primary trend is up, volume is expected to increase during market advances.

The chart in Figure 12.49 shows expanding volume during an up trend, confirming the primary trend.

The successful application of the Dow theory lies in the basic assumption that a trend is always prevalent in the market. An up trend is defined by a series of higher highs and higher lows. In order for an up trend to reverse, prices must have at least one lower high and one lower low. Thus, following a price reversal, a pattern change in prices is expected.

When the Sensex signals a reversal in the primary trend, the Dow theory expects a new trend formation immediately. However, the longer a trend continues, the odds of the trend remaining intact become progressively smaller. The chart in Figure 12.50 shows how the Sensex registered a higher high (point “A”) and a higher low (point “B”), which identified a reversal of the downtrend (line “C”).

The Dow theory helps investors identify facts, not to make forecast. Predicting the market is a difficult, if not impossible, game. While the Dow theory may be able to form the foundation for analysis, it was meant as a starting point for investors to develop their own trading strategies.

Reading the markets is an empirical science. As such there will be exceptions to the theorems put forth by Dow. Dow believed that success in the markets required serious study and analysis. Technical analysis is an art form and pattern formations are apparent with practice. Technical analysts hence, usually study both successes and failures with an eye on future.

ELLIOTT WAVE THEORY

Another theory based on technical analysis is the Elliott Wave Principle. The basis of this theory was developed from the observation that rhythmic regularity had been the law of nature. Elliott noted that all cycles in nature—whether of tide, weather, or life—had the capability of repeating themselves indefinitely. Two forces, one building up and the other tearing down, characterised these movements. Elliott noted in an 80 year period that the market moved forward in five waves and then declined in a series of three waves, as depicted in Figure 12.51.

Ralph Nelson Elliott developed the Elliott Wave Principle in the late 1920s by discovering that stock markets, thought to behave in a somewhat chaotic manner, in fact, did not. They did, however, trade in what he called repetitive cycles, which he discovered were the emotions of investors, caused by outside influences, or predominant psychology of the masses at the time. He had stated that the upward and downward swings of mass psychology always showed up in the same repetitive patterns, which were then divided into patterns he termed ‘waves’. The theory is somewhat based upon the Dow theory inasmuch as price movements also move in waves. Chartists believed that due to this fractal nature of the markets, Elliott was able to breakdown and analyse markets in much greater detail. Fractals are mathematical structures, which on an ever smaller scale infinitely repeat themselves.

This allowed him to spot unique characteristics of wave patterns. An intermediate wave, which goes with the primary trend, always shows sub waves in its pattern. On a smaller scale, within each of the intermediate waves, sub waves will be found. In this smaller pattern, the same pattern repeats itself infinitely (these ever smaller patterns are labelled as different wave degrees in the Elliott Wave Principle).

Price movements can be divided into trends on the one hand and corrections or sideways movements on the other hand. Trends show the main direction of prices, while corrections move against the trend. In Elliott terminology these are called ‘impulsive waves’ and ‘corrective waves’.

An impulse wave formation (1,3, and 5) followed by a corrective wave (2 and 4) form an Elliott wave degree, consisting of trend and counter trend (Figure 12.51).

The following example (Figure 12.52) shows the difference between a trend (impulse wave) and a correction (sideways price movement with overlapping waves). It also shows that larger trends consist of (several) smaller trends and corrections, but the pattern is always the same. Very important in understanding the Elliott Wave Principle is the basic concept that wave structures of the largest degree are composed of smaller sub waves. These sub waves are in turn composed of even smaller sub waves, and so on, which all have more or less the same structure (impulsive or corrective) like the larger wave they belong to.

Elliott distinguished nine wave degrees, ranging from two centuries to hourly. These wave degrees are grand supercycle, supercycle, cycle, primary, intermediate, minor, minute, minuette and sub minuette. In theory, the number of wave degrees are infinite, in practice it is difficult to spot more than four or five wave degrees.

A general trading rule for applying the Elliott wave principle will be to recognise the number of patterns/ sub-patterns. Since all patterns or their sub-patterns are either 3 wave or 5 wave structures, it follows that a minimum of three waves will occur always, no matter what happens. Therefore, if the investors concentrate on the 3rd wave, either in an impulsive or corrective wave, there will be a strong probability of making a profit. The Elliott wave principle expects the same patterns to evolve over and over again, enabling an investor to forecast the markets.

The Elliott Wave Principle provides an effective method for trading. The patterns are sometimes easy to recognise, especially the strong impulsive waves. These patterns indicate where the market is heading, in what way (or structure) this will happen and under what circumstances the pattern will produce a stronger probability. Also, the pattern indicates when it is no longer valid due to the occurrence of price movement. This makes it possible to exactly determine the entry and exit points, which is an outstanding characteristic of the Elliott Wave Principle.

The key to forecasting markets lies in determining the probabilities of alternative scenarios. If we find several alternative patterns pointing in the same direction, the profit making opportunity is large.

Besides chart patterns, other indicators can also be added to the graph, such as trend lines and moving averages. The extension of these trends and moving averages is considered as a good indicator of future price movements.

Most technical tools and systems are trend following in nature, which means that they are primarily designed for markets that are moving up or down. They usually work very poorly, or not at all, when markets enter a lateral or trend less phases. It is during these sideways market movements that chartists experience their greatest equity losses. A trend following system, by its very definition, needs a trend in order to conduct its trading activity.

For a speculator or a frequent trader using charts, three types of steps can be taken in a market. They are to buy the shares when the prices are facing an up trend, sell the shares when the prices are showing a decline and do nothing when the prices are not showing any movement.

SUMMARY

Technical analysis does not consider values in the sense in which the fundamental analysis applies it. Fundamental analysis allows the analyst to forecast the holding period and the riskiness of this holding, but this does not help an investor in identifying a buy or sell action. Technical analysis, however, may be useful in timing a buy or sell action.

Pattern analysis may seem straightforward, but it is by no means an easy task. Any general share price chart is a combination of countless different patterns and its accurate analysis depends upon constant study and long experience. Knowledge of all share analysis methods, technical, fundamental and, above all, the ability to weigh opposing indications against each other, help in the identification of trends.

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. Careful and constant study is required for successful chart analysis.

CONCEPTS

• Line Chart	• Bar Chart
• Candlestick Chart	• Point and Figure Chart
• Support and Resistance	• Volume and Open Interest
• Dow Theory	• Elliott Wave Principle

SHORT QUESTIONS

1. What is technical analysis?
2. What are reversal patterns?
3. What are continuation patterns?
4. What is the purpose of technical analysis?
5. What is a volume chart?

ESSAY QUESTIONS

1. Explain the Dow theory.
2. Explain the process of technical analysis.
3. Explain the Elliott Wave theory.
4. Explain how technical analysis is useful to investors.
5. Explain the common patterns recognised by technical analysts.