This tutorial looks at what the basic philosophy and assumptions, as well as the advantages and disadvantages are regarding technical analysis. Furthermore, you will understand that there are different approaches to technical analysis. We will discuss Cycle and Wave Theory, as well as introduce Gann and Fibonacci Studies. We will also look at some tools used in technical analysis, such as trend analysis, as well as support and resistance, trend lines and various chart patterns. We end this section with an explanation of the use of arithmetic and logarithmic scaling in technical analysis.
The study of the share market has become divided into two schools of thought: fundamental analysis and, technical analysis. The following is a brief background of the history and concepts regarding the foundations of technical analysis. To understand more about technical analysis requires that one first understands fundamental analysis. The goal of this tutorial is to familiarise you with the technical approach that the financial community, including economists, considers today a valuable alternative or supplement to fundamental analysis.
Fundamental analysis is the examination of the underlying economic forces that affect the interests of the economy, industrial sectors and companies. The fundamental approach examines all the relevant factors affecting the price of a market in order to determine the intrinsic value of that market. The intrinsic value is what fundamentalists indicate something is actually worth based on the law of supply and demand. If this intrinsic value is under the current market price, then the market is overpriced and should be sold. If market price is below the intrinsic value, then the market is undervalued and should be bought.
Fundamental analysis looks at the financial statements of a company, which include the Balance Sheet, the Income Statement, and the Cash Flow Statement. Some analysts, for example, would analyse the company's balance sheet to determine the value of the company and try to buy the share at a price lower than the net asset value (NAV) of the company. Other fundamental analysts focus on the expected future earnings of the company and try to buy the share at a lower price compared to the future earnings (low PE ratio). Fundamental analysis helps to identify companies that represent good value, as well as good long-term opportunities. Fundamental analysis is the development of a thorough understanding of the business. Because shares move as a group, by understanding a company's business, investors can better position themselves to categorise shares within their relevant industry group. Industry groups are then compared against other industry groups and companies against other companies. Usually, companies are compared with others in the same group. However, it is hard to apply fundamental analysis for timing and this is where technical analysis can be useful.
Records exist from centuries ago in Japan, regarding the use of price charts (i.e. Japanese Candlesticks) to determine market direction. Even in the modern era, many people have amassed enormous fortunes utilising technical analysis. Charles Dow, of Dow Jones fame and the founder of the "Wall Street Journal" devised a method to discern cyclical patterns in share prices. Other sages such as Elliott put forth complex "wave theories". Technical analysts now regularly employ dozens of geometric configurations in their divinations.
Technical analysis has often been compared to voodoo, alchemy, and astrology. Economists, since the 1960's have sought to rebuff technical analysis. Markets, they say, are efficient and "walk" randomly. (See Random Walk Theory in tutorial 12). Prices reflect all the information known to market players including all the information pertaining to the future. The paradox is that technical analysts are more orthodox than the most devout academic. They adhere to the strong version of market efficiency. The market is so efficient, they say, that nothing can be gleaned from fundamental analysis. All fundamental insights, information, and analyses are already reflected in the price. This is why one can deduce future prices from past and present ones.
Similarly, substantive news, change in management, an oil shock, a terrorist attack, an accounting scandal, a major contract, or a natural or man-made disaster, all cause share prices and market indices to break the boundaries of the price band that they have occupied. Technical analysts identify these boundaries and trace breakthroughs and their outcomes in terms of prices.
Technical analysis looks for peaks, bottoms, trends, patterns, and other factors affecting a share's price movement and then making a buy or sell decision based on those factors. It is a technique many people attempt though very few are truly successful. Unlike the fundamental analyst, the technical analyst is not concerned with the intrinsic value of the share and the reasons for share-price movements, believing that all the fundamental information is already factored into their charts and reflected in the resultant share price. The technical analyst aims to buy as near to the starting point of an upward cycle in a share's price, and to sell as near to the top of the cycle as possible. It should be borne in mind that technical analysis is more of an art than an exact science - five different technical analysts may well express five different opinions about the same chart.
Technical analysis focuses on market sentiment and assesses the share in terms of its popularity in the eyes of investors. The technical analyst makes the assumption that the past movements of share prices allow us to determine the probability of future price moves in any given direction: up, down or sideways. The technical analyst makes use of graphs and statistical techniques to study historical price and volume patterns in order to predict the future course of share prices. In this way technical analysis aids us in our decisions regarding when it is best to buy or to sell shares.
Technical Analysis is the study of market action, primarily through the use of charts, for the purpose of forecasting future price trends. The term "market action" includes the two principal sources of information available to the technician, which is price and volume. Technical analysis is a price prediction method founded in the belief that current prices represent, and are derived from all known information about a share. If people buy and sell based upon knowledge acquired through whatever means, then one could argue that prices themselves are a reflection of all market participants and their corresponding knowledge. This is the premise that technical analysis is founded upon.
Not only do prices reflect intrinsic facts, they also represent human emotion and the pervasive mass psychology and mood. Prices are a function of supply and demand, and human emotions…fear, greed, panic, hysteria, elation, etc. Markets may move based upon people's
expectations, not necessarily facts. A market "technician" attempts to disregard the emotional component of trading by making his decisions based upon recurrent price chart formations.
There are three premises on which the technical approach is based:
- Market action discounts everything. The technical analysts believes that anything that can possibly affect the price fundamentally, politically, psychologically, or otherwise, is already reflected in the price of that market. It follows, therefore, that a study of price action is all that is required.
- Prices move in trends. The whole purpose of charting the price action of a market is to identify trends in early stages of their development for the purpose of trading in the direction of those trends.
- History repeats itself. The key to understanding the future lies in a study of the past, or that the future is just a repetition of the past. Patterns in the market are based on human psychology, which tends not to change.
In accepting the premises of technical analysis, one can see why technicians believe their approach is superior to the fundamentalists. If a trader had to choose only one of the two approaches to use, the choice would logically have to be the technical. Because, by definition, the technical approach includes the fundamental. If the fundamentals are reflected in market price, then the study of fundamentals becomes unnecessary. Chart reading becomes a shortcut form of fundamental analysis. The reverse, however, is not true. Fundamental analysis does not include a study of price action. It is possible to trade financial markets using just the technical approach. It is doubtful that anyone could trade off the fundamentals alone with no consideration of the technical side of the market.
Technical analysts have flourished and waned in line with the stock exchange bubble. They and their multi-coloured charts regularly graced CNBC, the CNN and other market-driving TV channels. "The Economist" magazine found that many successful fund managers have regularly resorted to technical analysis, including George Soros' Quantum Hedge fund and Fidelity's Magellan fund. Technical analysis may experience a revival now that corporate accounts, the fundament of fundamental analysis have been rendered unreliable by seemingly inexhaustible scandals.
Technical analysis may be nothing more than a self-fulfilling prophecy, though. The more devotees it has, the stronger it affects the shares or markets it analyses. Investors move in herds and are inclined to seek patterns in the often bewildering marketplace. As opposed to the assumptions underlying the classic theory of portfolio analysis, investors do remember past prices. They hesitate before they cross certain numerical thresholds.
But this herd mentality is also the Achilles heel of technical analysis. If everyone were to follow its guidance it would have been rendered useless. If everyone were to buy and sell at the same time based on the same technical advice, price advantages would have been arbitraged away instantaneously. Technical analysis is about privileged information to the privileged few, though not too few, lest prices are not swayed.
Studies have shown that a filter model such as trading with technical analysis is preferable to a "buy and hold" strategy but inferior to trading at random. Trading against recommendations issued by a technical analysis model and with them, yielded the same results. The proponents of technical analysis also claim that rather than forming investor psychology, it reflects their risk aversion at different price levels. Moreover, the borders between the two forms of analysis (i.e. technical and fundamental analysis) are less sharply demarcated nowadays. "Fundamentalists" insert past prices and volume data in their models, while "technicians" use dividend streams an
d past earnings in theirs.
It is not clear why fundamental analysis should be considered superior to its technical alternative. If prices incorporate all the information known and reflect it, predicting future prices would be impossible regardless of the method employed. Conversely, if prices do not reflect all the information available, then surely investor psychology is as important a factor as the company's, now often discredited financial statements?
Prices, after all, are the outcome of numerous interactions among market participants, their greed, fears, hopes, expectations, and risk aversion. Surely studying this emotional and cognitive landscape is as crucial as figuring the effects of cuts in interest rates or a change of CEO?
Still, even if we accept the rigorous version of market efficiency i.e. that market prices are unbiased estimates of the true value of investments, prices do react to new information and, more importantly, to anticipated information. It takes them time to do so. Their reaction constitutes a trend and identifying this trend at its inception can generate excess yields. On this both fundamental and technical analysis are agreed.
Moreover, markets often over-react: they undershoot or overshoot the "true and fair value". Technical analysis calls this oversold and overbought markets. The correction back to equilibrium prices sometimes takes years. A savvy trader can profit from such market failures and excesses.
When attempting to forecast share price movement, many people make the mistake of relying on the day-to-day belated information from the mainstream media. An evening news report about a rock fall at one of the gold mines, a radio blurb from an analyst regarding the near-term direction of interest rates, or even a "hot" tip from a third-cousin-twice-removed about a building and construction company who just landed a big contract, are all examples of "fundamental" market information. A person who makes an attempt to forecast a future price movement through the assessment of supply and demand factors is called a "fundamentalist." As with any methodology of analysis, there are flaws to fundamental trading, especially for shorter-term traders.
Many people seem to forget that there are many other people who all know similar information at the same time. Central banks, multi-national conglomerates, and global financial institutions knew the same information long before they did, and acted upon it! These entities employ literally millions of people, and spend billions on technology to keep a second-by-second assessment of world events. Thinking that one can act first, and make a trading decision based on public, out-dated information, will almost certainly guarantee failure. This is not to say fundamentals are meaningless, they just are not as relevant for a shorter-term trader.
Long-term trends that last for several months to years can sometimes be accurately forecasted by a savvy fundamentalist, and there are many professional traders who incorporate fundamentals into their trading. The problem is, most average traders do not have the focus to maintain a distant time horizon, and they allow the day-to-day fluctuations to alter their original conviction on market direction. Others would not allocate enough time and energy to researching, digesting, and absorbing all the relevant materials. If there were a way to conveniently assimilate information, and view it graphically to identify patterns, would not market forecasting be easier?
Investment research and methodology
The more time you put into the investment process, the more robust it will be. But the only way to maintain on-going success is constantly
tweaking and modifying your investment process. The only way to continue making money, to continue growing and keeping your profit margins healthy, is to constantly examine your assumptions and come up with new investment ideas.
Both the technical and the fundamental approach to understanding market trends have the same objective; they seek to answer the question 'in what direction are share prices likely to go?' They simply approach the problem from different angle.
The fundamentalist will try to understand what causes the market movement, while the technician analyses the effect. The problem is that the charts and fundamental data often contradict each other. Usually at the start of and important market move, the fundamental data does not explain or support what the market seems to be doing. It is at these critical times in the trend that these two approaches seem to diverge the most. Usually they converge at some point, but often too late for the trader to act.
One explanation for these seeming discrepancies is that market price tends to be ahead of, or lead the reasons for the price change or known fundamentals. While the known fundamentals have already been discounted and are already "in the market", prices are now reacting to the unknown fundamentals. Some of the most dramatic bull and bear markets in history have begun with little or no perceived change in the fundamentals. By the time those changes are detected and understood, the new trend was well underway.
Many traders know that a technique such as technical analysis is only as good as its interpreter. As with many techniques of analysis, there is always room for numbers and graphs to be interpreted in a range of different ways. It takes patience, discipline, and practice to develop your own personal trading and analysis style.
There is a wide range of techniques, indicators, and variations on chart interpretation available to new investors. Not all will be suitable for every trader. It is easy to over- complicate technical analysis; it is therefore important to remember that all technical analysis charts make use of the same basic information i.e. price, volume and time.
Use the guidance in this tutorial to help you fine-tune a methodology that works well for you.
Basic philosophy and assumptions
The basic philosophy and assumptions underlying technical analysis can be summarised as follows:
- Market value of a share is determined solely by the interaction of supply and demand.
- Supply and Demand is governed by numerous factors, both rational and irrational. Such factors include those relied upon by the fundamentalists, as well as opinions, moods, guesses, and necessities. The market automatically weighs up these factors on a continuous basis.
- Disregarding minor fluctuations in the market, share prices tend to move in trends that persist for an appreciable length of time.
- Changes in trends are caused by the shifts in supply and demand relationships. These shifts, whatever the reasons for their occurrence, can be detected sooner or later in the action of the market itself.
- History tends to repeat itself resulting in recurring cycles or trends.
Advantages and disadvantages
Technical analysis has been part of financial practice for many decades, but this discipline has not received the same level of academic scrutiny and acceptance as more traditional approaches such as fundamental analysis. One of the main obstacles is the highly subjective nature of technical analysis; the presence of geometric shapes in historical price charts is often in the eyes of the beholder.
One of the dominant debates in financial market analysis is the relative validity of the two major tiers of analysis: Fundamental and technical. In several studies it has been concluded that fundamental analysis was more effective in predicting trends for the long-term (longer than one year), while technical analysis was more appropriate for shorter time horizons (0-90 days). Combining both approaches was suggested to be best suited for periods between 3 months and one year. Nonetheless, further empirical evidence reveals that technical analysis of long-term trends helps identify longer-term technical "waves", and that fundamental factors do trigger short-term developments.
advantages of technical analysis over fundamental analysis can be summarised as follows:
- With technical analysis, it must be pointed out that trading rules are picking up patterns in the data not accounted for by standard statistical models and that the excess returns thus generated are not simply a risk premium.
- Whilst fundamental information is quite easy to come by (newsletters newspapers, financial magazines etc.) few people have the time to really sift through the mountains of material, and if they do, how are they supposed to react to the conflicting opinions and contradictory evidence so frequently encountered or to interrelate the various factors operating simultaneously? In contrast, technical analysis leaves the processing and evaluation of all fundamental information to the market itself which reflects the impact thereof in the resultant share price.
- Fundamental analysts are often faced with the difficulties surrounding impartiality (or lack thereof) on the part of the person or institution compiling the information. There are many well-documented cases of stockbroker bias in favour of large institutional clients, or newspapers promoting the stocks or corporations which advertise extensively in their publication, or politicians pronouncements being biased in favour of their political aspirations. Technical analysis tends to be able to divorce themselves from the news of the day and subjective opinions to a greater extent, given their lack of interest in the reasons for share price movements.
- Fundamentalists have problems as regards timing as stock markets nearly always make their major turns well ahead of the economy. In other words, fundamental analysis relies on current information for its analysis, and the market often turns before fundamental analysts can gather such information and interpret its implications. In contrast technical analysis uses historically based information in order to predict future changes in share prices.
- Fundamental analysis has difficulty coping with the effects of mass psychology. Even if the fundamental analyst can determine with a fair degree of accuracy what the future earnings of a company are likely to be, they still have no way of determining how much the market will be prepared to pay for those earnings which, of course, may be a vital determinant of price. Technical analysis, on the other hand, incorporates human psychology in the projection of a future share price, such sentiments being discounted by market action.
Technical analysis is, however, not without its own
- The first problem is that it is theoretic and data intensive, while pattern over-fitting can be a problem, its rules are often difficult to interpret, and the statistical testing is cumbersome.
- The second problem facing technical analysis relates to overuse. As the popularity of technical analysis has increased, more and more investors are looking at the same charts and coming to the same conclusions. When too many people use the same system the likelihood of them being proved wrong increases. This is what may be starting to happen now as a result of the widespread acceptance of computerised chart analysis. Indeed there is evidence suggesting that many disillusioned investors who embraced the procedure so enthusiastically a few years ago are now discarding it.
- Thirdly, technical analysis is very much a function of extrapolation i.e. based on the assumption that what has happened in the immediate past will continue into the future. A trend remains in existence until proved otherwise. The danger inherent in such an approach becomes evident if one accepts that 'trends don't last forever' - the longer one has been in existence, the nearer it gets to its ultimate turning point. When, for instance, prices have been rising for a prolonged period, most investors come to believe that further price rises are inevitable, and vice versa. This is the reason why the ultimate turning point is so often missed - they recognise a new trend only sometime after the old one has expired, by which time a good deal of the profit potential may have been lost.
- Lastly, a further disadvantage of only using technical analysis is that one becomes far removed from the original objective of a stock market. The idea is to invest in businesses. By buying a share you gain shared ownership of a business. Most pure technical analysts have no idea what business their companies are involved in, or how well these businesses are doing.
Technical analysis has become popular over the past several years, as more and more people believe that the historical performance of a share is a strong indication of future performance. Technical analysis is one of those fields where everyone has a different theory on what works and what does not. In our humble opinion, technical analysis is a terrific tool, but much more effective when combined with fundamental analysis.
In this section, we will examine different approaches to technical analysis, such as:
- Kondratieff Cycle Theory
- Elliot Wave Theory
- Fibonacci Studies
Wave or cycle theories
These theories are based on the assumption that 'history repeats itself'. The simple distinction between wave and cycle theories can be described as follows.
- Cycle theories postulate a regular time frame, whereas wave theories postulate a regular pattern. The terms are not interchangeable although many analysts do not distinguish between the two. Cycle theorists maintain that shares, share markets, sectors, commodities and almost every commercial data stream, move in regular waves which are consistent in length. Numerous cycles are assumed to operate simultaneously, major peaks and troughs occurring when the action of several cycles fall into line. The Kondratieff theory is an example of a cycle theory.
- Wave theorists propose that share prices move in a specific wave sequence, the amplitude and length of each pattern being variable. The Elliot Wave Theory is perhaps the most sophisticated wave theory model.
Kondratieff cycle theory
According to Wikipedia, Russian economist Nikolai Kondratieff was the first to chart and describe waves (now known as Kondratieff waves, K-waves or the long economic cycle) recording cycles in the modern capitalist world economy. Averaging fifty and ranging from approximately forty to sixty years, the cycles consist of alternating periods between high sectorial growth and periods of relatively slow growth. This long wave theory is not accepted by current mainstream ec
Kondratiev wrote about his observations in his book
The Major Economic Cycles, which was published in 1925. His conclusions were seen as a criticism of Joseph Stalin's intentions for the Soviet economy: as a result he was sentenced to the Soviet Gulag and later received the death penalty in 1938.
In the 1920s Kondratieff noticed that since the start of the industrial revolution, capitalist economies had experienced long waves of growth and contraction or cycles of boom and bust.
He recorded 25-35-year waves of increasing prosperity and living standards followed by a decade or more of depression, during which time factories lay idle, crops go un-harvested and legions of the working class lose their jobs and become demoralised. In his view, severe economic upheavals came at fairly regular 45-to 60-year intervals. Internal rebalancing and depressions then helped to start succeeding upturns. Kondratieff's study covered the period 1789 to 1926 and was centred on prices and interest rates.
There are many websites that discuss and analyse the merits of the Kondratieff cycle theory. Some are listed below.
Four phases of one cycle
A Kondratieff Cycle consists of four distinct phases and vivid mood changes, the tone of which determines the actions of individuals involved in the economy. The awareness of these characteristics allows for the anticipation of the change in the economy and the psychological mood that will prevail.
The four distinct phases are as follows:
- Beneficial inflation (spring),
- Stagflation (summer),
- Beneficial deflation (autumn), and
- Deflation (winter).
Since, the last Kondratieff cycle ended around 1949, we have seen beneficial inflation 1949-1966, stagflation 1966-1982 and beneficial deflation 1982-2000 and according to Kondratieff, we are now in the (winter) deflation cycle which started in 2000 and should end in about 2020.
Inflationary growth phase - Spring
A common premise among business cycle economists supposes inflation as an inevitable part of growth. Government becomes a passive participant in the inflation cycle. Growth begins from a depressed economic base and expands in an ever-increasing spiral. The interaction of the participants within the economy causes wealth, as represented by savings and the production of capital equipment to be accumulated for the future. The expansion of production and affluence causes prices to rise, and the increased volume of goods requires a higher requires a higher rate of money changing hands, which in turn creates a higher price structure.
Historically, the growth phase requires 25-years to complete. During this time, unemployment falls, wages and productivity rise and prices remain relatively stable. The mood of the growth phase is one of accumulation and the desire for new product manufacture.
As wealth is accumulated and new innovation introduces great upheavals and displacements take place. The process of social unrest builds with growth culminating in massive shifts in the way work is defined and the role of the participants in society.
Stagflation (Recession) - Summer
Eventually, the continuation of exponential growth reaches its limits. Excess capital produces a shortage of key resources and the economy enters a period where growth creates a shortage of resources. An economy will only support expansion to the limits of its resources, both human and material.
The mood of affluence also brings a change in attitude towards work. As an economy gets closer to its limits, inefficiencies build up. The imbalances of this period have been historically exaggerated by what can be labelled a "peak war". Examples such as War of 1812, the Civil War, World War I and Vietnam, came at the end of a very affluent period. These Wars produce strains on the economy increasing the impact of inflation. A dramatic drop in output, rapid rise in unemployment and unusually severe recession characterise this period.
Although this primary recession is short lived lasting only three to five years, it is the key in altering perceptions and the structure of the economy. No longer does excess create abundance. The "Limits to Growth" now define a maximum level of economic activity that traps the economy into consolidation and tight bounds for the next 20-25 years. With the change comes a conservative shift in the popular mood reinforcing the limits.
Deflationary growth (Plateau period) - Autumn
The primary recession occurs out of an imbalance forced upon the economy by real limitations. The rapid rise in prices and changes in production correct this imbalance, at least temporarily. The change in price structure, along with the mood of a population used to consumption accompanied by the vast accumulation of wealth from the past 30 years, causes the economy to enter a period of relatively flat growth and mild prosperity. Due to structural changes and the limits of the existing paradigm the economy becomes consumption oriented.
Excesses of an unpopular war, along with fiscal liberalism, cause popular reaction toward stability or normalcy. A mood of isolationism permeates. The plateau period generally lasts seven to ten years and is characterised by selective industry growth, development of new ideas (both technological and social) and strong feelings of affluence, terminating in a feeling of euphoria.
The inflated price structure from the primary recession, along with the desire for consumption, produces a rapid increase in debt. Eventually, wealth consumption expands beyond all practical limits, and economy slips into a severe and protracted depression.
Depression - Winter
Excesses of the plateau period affect a collapse of the price structure. This exhaustion of accumulated wealth forces the economy into a period of sharp retrenchment. Generally, the secondary depression entails a three year collapse, followed by a 15-year deflationary work out period. The deflation can best be seen in interest rates and wages that have shown a historic alignment with the timing of the Long Wave - peaking with and bottoming at the extremes.
Kondratieff viewed depressions as cleansing periods that allowed the economy to readjust from the previous excesses and begin a base for future growth. The characteristic of fulfilling the expectations of the previous period of growth is realised within the "Secondary Depression" or "Down Grade." This is a period of incremental innovation where technologies of the past period of growth are refined, made cheaper and more widely distributed. Incremental innovation consolidates industries.
The "Down Grade" sees one final period of recession before transitioning to a new period of growth. The final recession is mild with very low inflation and appears far more severe than it will be remembered for later in the Growth Cycle.
Within the Down Grade is a consolidation of social values or goals. Ideas and concepts introduc
ed in the preceding period of growth while radical sounding at the time become integrated into the fabric of society. Often these social changes are supported by shifts in technology. The period of incremental innovation provides the framework for social integration.
The table below summarises the generally accepted phases since 1784 in the United States. You will notice the significant wars that have accompanied the recession (price peak) and depression (trough) phase. Upi will also notice the "tag name" for the autumn periods that were characterised by massive debt growth and speculative bubbles.
Many have argued as to whether the Kondratieff Cycle is valid for the post World War II economy given the fiscal and monetary tools of a modern economy. Others have argued that the trough of the Kondratieff Cycle has already passed. Their count is from the trough of the Great Depression in 1932. Add the average 54-year Kondratieff Cycle period and you will find that we are in the spring expansion of the new Kondratieff Cycle.
Study of debt growth
The Kondratieff Cycle is really about long cycles of growth in debt and then the rejection thereof. It is not exclusively about price inflation and deflation periods. Deflation is caused in part by the debt collapse.
Many analysts take the last Kondratieff Cycle to have made its final trough in 1949 when interest rates and prices bottomed. The effects of the Great Depression were softened by World War II and it was in the 1950's that the world firmly started to shake off the long two decades of depression and war. The Kondratieff Cycle has followed quite true to form with the solid growth and low inflation of the 1950's and 1960's followed by the commodity/price inflation and recession driven 1970's. Commodity prices peaked in 1980.
Following the steep secondary recession of the early 1980's the markets embarked into the autumn Kondratieff Cycle plateau.
As occurred at the end of previous autumn plateau Kondratieff Cycle (1920-1929), the win
ter that followed revealed numerous financial scandals and was no different. The collapse of Enron and WorldCom were big and visible but are they merely the tip of the iceberg. The autumn plateau Kondratieff Cycle brought on excesses in both the share market and the corporate boardroom. Even the early part of the autumn plateau Kondratieff Cycle, there were the insider trading scandals of the 1980's followed by the debt implosion and scandals of the Savings & Loans. If the 1990's were a decade of loss of faith in governments for its excesses of debt build-up then the first two decades of the millennium will see the same occurring with capitalism and the corporation.
One of the more interesting features of a Kondratieff Cycle winter is the build-up of sinister forces that are religious in nature. In an earlier generation Kondratieff Cycle winter in the latter quarter of the 19th century we saw the rise of the Klu Klux Klan (KKK) as a backlash to the South losing the Civil War. The 1930's saw the rise of Nazism that led to World War II.
Today it is the so-called war on terrorism led allegedly by Muslim fundamentalist fanatics. There is a titanic religious war being played out. The Arab/Palestinian/Israeli conflict continues to grab the world's attention, as well as the imagination of conservative evangelistical religions in the United States. It is their belief that the current conflict was ordained in the Bible and will ultimately lead to the apocalypse.
The winter of the Kondratieff Cycle is upon us proponents of the theory believe that it is a dangerous period. But it will be lessened for those holding gold bullion or gold shares. That new bull market is still in its infancy and may yet face a significant shakeout to make its final bottom. The Kondratieff Cycle is the rise and fall of a generation and covers both the social and economic life of the period. Our challenge then will be to see that we come through so that once again we can rebuild.
Sources and further reading
Kondratieff Waves and the Greater Depression of 2013 – 2020, Market Oracle:
If Kondratieff was right about super-cycles, we've still got years of slump to go, by Jeremy Warner, published in The Telegraph, 5th October 2012. blogs.telegraph.co.uk
The Kondratieff Cycle Theory:
Elliot wave theory
According to Wikipedia, the Elliott Wave Principle is a form of technical analysis that some traders use to analyse financial market cycles and forecast market trends by identifying extremes in investor psychology, highs and lows in prices, and other collective factors.
Ralph Nelson Elliott (1871–1948), was a professional accountant who discovered the underlying social principles and developed subsequent analytical tools in the 1930s. He proposed that market prices unfold in specific patterns, which practitioners today call Elliott waves, or simply waves. Elliott published his theory of market behaviour in the book
The Wave Principle in 1938, summarised it in a series of articles in Financial World magazine in 1939, and covered it most comprehensively in his final major work, Nature's Laws: The Secret of the Universe in 1946.
Elliott stated that "because man is subject to rhythmical procedure, calculations having to do with his activities can be projected far into the future with a justification and certainty heretofore unattainable." The empirical validity of the Elliott Wave Principle remains the subject of debate.
Some ardent followers of the Elliot wave theory have called it "the purest form of technical analysis".
One of the best places to see this spectacle is in the share market, where shifting investor psychology is noted in share price movements. Price movements show the way that the crowd goes from the extreme point of optimism at the top to the extreme point of pessimism at the bottom. It describes the steps that human beings go through when they are part of the investment crowd. They change their psychological orientation from bullish to bearish. Since people do not change much; the path they follow in moving from extreme optimism to extreme pessimism and back again tends to be repeated over and over again, regardless of news and irrelevant events.
The Basic Elliot Wave Pattern
The main strengths behind the Elliott wave theory is one of "building up" and "pulling down." The basic idea of the Elliott wave theory are detailed below.
- Newton's law of motion states that "Every action creates an equal and opposite reaction." In the share market, we can see this in price movements up or down, as they are followed by an opposing movement. Price action is divided into bullish or bearish trends, and corrections or rallies, or sideways or neutral movements. The bullish or bearish trend of the market shows the main direction of prices, while corrections or rallies move against the major trend. Elliot labelled these as "Impulsive waves" and "Corrective waves."
- There are five waves in the direction of the main trend, followed by three corrective waves (a "5-3" move).
- A 5-3 move completes a cycle. This 5-3 move then becomes two sub-divisions of the next higher 5-3 wave.
- The underlying 5-3 pattern remains constant, though the time span of each may vary.
- The basic pattern is made up of eight waves (five up and three down) which are labelled 1, 2, 3, 4, 5, a, b, and c.
In the share market, progress eventually takes the form of five waves of a specific structure. Waves (1), (3) and (5) actually affect the directional movement. Waves (2) and (4) are counter trend breaks. The two breaks are apparently a requisite for overall directional movement to occur. The share market is always somewhere in the basic five-wave pattern at the largest degree of trend. Because the five-wave pattern is the principal form of market progress, all other patterns are incorporated into it.
The Elliot wave theory may be used in all time frames. Waves come insteps, the smaller being the building blocks for the larger. The waves link together to form larger versions of themselves, and they also link together to form the same patterns at the next larger size, and so on. Some of the largest wave patterns span hundreds of years, while some of the smallest span a few hours. That is why Elliott wave theory is useful for predicting market movements in all time frames.
The Elliott wave theory is somewhat based upon the Dow Theory in that price movements also move in waves. Because of the fractal nature of the markets, Elliot was able to analyse the markets in much greater detail. This allowed him to spot unique characteristics of wave patterns and helped him make detailed market predictions based on the patterns he identified.
Fractals are mathematical constructs which on an ever-smaller scale infinitely repeat themselves. The patterns that Elliott discovered were built in a similar way. According to Elliot Wave International (
http://elliotwave.net), an impulsive wave, which goes with the main trend, always shows five waves in its pattern. On a smaller scale, within each of the impulsive waves, another five waves would be found. In this smaller pattern again, the same pattern is repeated to infinity. These ever smaller patterns are labelled as different wave degrees in the Elliott wave theory.
The three waves in the direction of the trend are called impulses and these waves also have five waves. The waves against the trend are called corrections and are composed of three waves.
The corrective wave formation normally has three, in some cases can have five or more distinct price movements, two in the direction of the main correction (A and C) and one against it (B). Wave 2 and 4 in the image above are called corrections. These waves have the following structure:
Note that these waves A and C go in the direction of the shorter term trend, and therefore are impulsive and composed of five waves, which is shown in the picture above.
Note that these waves A and C go in the direction of the shorter term trend, and therefore are impulsive and composed of five waves, which is shown in the image above.
An impulse wave formation followed by a corrective wave and this forms an Elliott wave degree as it consists of trend and counter trend. Although the patterns pictured above are bullish, the same applies for bear markets, where the main trend is down. Waves may be subdivided to establish different degrees of trend. The Elliott Wave theory has assigned a series of categories to the waves in order of the largest to the smallest. They are called the "Grand Super Cycle", the "Super Cycle", the "Cycle", the "Primary Cycle", the "Intermediate Cycle", the "Minor Cycle" and the "Minute Cycle".
To use the Elliot wave theory in everyday trading, the trader must determine the "Main Wave" or "Supercycle", and then enter a trade when it is bullish or exit a trade when it becomes bearish as the pattern runs out of steam and a price reversal is around the corner.
The main difference between the Elliott wave theory and other cyclical theories is that this theory suggests no absolute time requirements for a cycle to complete. Remember that the principal reason for using the different wave and cycle theories is to determine the future trend of a share. The technical analyst aims to buy as near to the starting point of an upward cycle in a share's price, and to sell as near to the top of the cycle as possible.
The Elliott wave theory is especially well suited to these functions. If you can identify repeating patterns in prices, and figure out where in those repeating patterns we are today, then you can predict where we are going in the future. Nevertheless, the Elliot Wave Theory does not provide
certainty about any one market outcome; rather, it provides an objective means of assessing the relative probabilities of possible future paths for the market
Someone who is able to identify the market structure and then anticipate the most probable move next based on their position within the structure, is called an "Elliottician." By understanding the wave patterns, traders can anticipate what the market could probably do next and (sometimes more importantly) what it will
not do next. By using the Elliot Wave Theory, you can be sure of the highest probable moves with the least risk.
Elliott Wave Theory:
According to Wikipedia the Fibonacci sequence appears in Indian mathematics, in connection with Sanskrit prosody. In the Sanskrit oral tradition, there was much emphasis on how long syllables mix with the short, and counting the different patterns within a given fixed length results in the Fibonacci numbers.
Quoted in Wikipedia, Susantha Goonatilake wrote that the development of the Fibonacci sequence "is attributed in part to Pingala (200 BC), later being associated with Virahanka (c. 700 AD), Gopāla (c. 1135), and Hemachandra (c. 1150)".
In the West, the Fibonacci sequence first appeared in the book Liber Abaci (1202) by Leonardo of Pisa, a mathematician known as Fibonacci. He is known to have discovered a simple numerical series that is the foundation for an incredible mathematical relationship that became known as the "Fibonacci numbers."
The Fibonacci numbers are the sequence of numbers where the sum of the two preceding numbers is added together. For example: 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, etc.
Do you understand how the series is formed and how it continues? Just add the last two to get the next …144, 233, 377, 610, 987, etc.
The Fibonacci number sequence is not all that important but rather the number of interrelationships it possesses. The fact that any given number is approximately 1.618 times the preceding number is amazing!. In other words, it is the quotient of the adjacent terms that possesses an amazing proportion, roughly 1.618, or its inverse 0.618. This proportion is known by many names such as the "golden ratio", and the "golden mean", among others.
If you take the ratio of two successive numbers in the Fibonacci series, (1, 1, 2, 3, 5, 8, 13,...) and we divide each by the number before it, we will find the following series of numbers: 1/1 = 1, 2/1 = 2, 3/2 = 15, 5/3 = 1666..., 8/5 = 16, 13/8 = 1625, 21/13 = 161538, and so on
You will notice that the ratio seems to be settling down to a particular value, which we call the "Golden ratio," which has a value of approximately 1.618034.
Fibonacci ratio in nature
So, why is this number so important? Fibonacci numbers have an uncanny ability to describe a variety of natural relationships in nature to maintain balance. Almost everything has dimensional properties that adhere to the ratio of 1.618. It seems to have a fundamental function in nature, where everything from atoms, to petal arrangement on flowers, to the shape of the spiral in a Nautilus shell, to the most advanced patterns in the universe such as unimaginably large celestial bodies are just some of the examples
The Fibonacci studies and finance
When used in technical analysis, the Golden ratio anticipates changes in trends as prices tend to be near lines created by the Fibonacci studies, typically translated into three percentages: – 38.2%, 50%, and 61.8%. However, more multiples can be used when needed, such as 23.6%, 161.8%, 423%, and so on. There are four popular Fibonacci studies used for applying the Fibonacci sequence to finance, namely Fibonacci Retracements, Fibonacci Arcs, Fibonacci Fans, and Fibonacci Time Zones.
Fibonacci retracements use horizontal lines to indicate areas of support or resistance. They are calculated by first locating the high and low of the chart. Then five lines are drawn: the first at 100% (the high on the chart), the second at 61.8%, the third at 50%, the fourth at 38.2%, and the last one at 0% (the low on the chart). After a significant price movement up or down, the new support and resistance levels are often at or near these lines. Take a look at the chart below, which illustrates Fibonacci retracements in a rising market.
Finding the high and low of a chart is the first step to composing Fibonacci arcs. Then, with a compass-like movement, three curved lines are drawn at 38.2%, 50%, and 61.8%, from the desired point. These lines anticipate the support and resistance levels, and areas of ranging. Take a look at the chart below, which illustrates how these arcs do this.
Fibonacci fans are composed of diagonal lines. After the high and low of the chart is located, an invisible vertical line is drawn though the rightmost point. This invisible line is then divided into 38.2%, 50%, and 61.8%, and lines are drawn from the leftmost point through each of these points. These lines indicate areas of support and resistance. Take a look at the chart below.
Fibonacci Time Zones
Unlike the other Fibonacci methods, time zones are a series of vertical lines. They are composed by dividing a chart into segments with vertical lines spaced apart in increments that conform to the Fibonacci sequence (1, 1, 2, 3, 5, 8, 13, etc.). These lines indicate areas in which major price movement can be expected. Take a look at the chart below, which illustrates how these time zones do this.
Disadvantages with Fibonacci Studies
Fibonacci numbers have proven themselves as tools for identifying support and resistance levels in markets. The challenge for a trader lies in learning how to apply them quickly and easily in multiple time frames and using them to trade.
The most common technical analysis charting programs include Fibonacci retracements, arcs, fans, and time-frame tools. But by the time the trader has applied these tools to multiple pivot points in multiple time frames, the chart is barely comprehensible, let alone useful for making trading decisions. As a result, most traders use these tools in only a single time frame with only one or two pivot points. While the resulting chart is easy to read, the lines are often not very significant and therefore not reliable because too much data is being ignored.
The reason for this dilemma in using Fibonacci tools is simple. Long-term observations and studies have shown that Fibonacci retracement levels, calculated using numerous pivot point swings in multiple time frames, work best in the zones in which they join. The more often these lines touch at or near a single price level, the more significant and therefore reliable they become in determining potential consolidation or reversal points.
Fibonacci studies are not intended to provide the primary indications for timing the buy (entry) and sell (exit) points of a share; but rather they are useful for determining areas of support and resistance. Many people use combinations of Fibonacci studies to obtain a more accurate forecast.
A trader, for example, may observe the intersecting points in a combination of the Fibonacci arcs and resistances. Many more use the Fibonacci studies in conjunction with other forms of technical analysis such as Elliott Waves to predict the extent of the retracements after different waves. Hopefully you can find your own niche use for the Fibonacci studies, and add it to your set of trading tools!
Tools of Technical Analysis
Market prices are determined by the
expectations of those already in the market and those contemplating getting in. The price of a specific share at any one time is determined by the knowledge, hopes, fears and expectations of all those people who already own it or who might be thinking about owning it.
If you are sitting with cash, you are affecting the price just as much as anyone who has bought the share – for by holding back from making the purchase, you are keeping the price lower than it otherwise would be. In other words, it is the underlying forces of
supply and demand that cause a market to move up and down.
Secondly, prices are determined by changes in
mass psychology. Markets reflect human action, and people tend to make the same mistakes. Human nature is more or less constant. Fortunately, these constant emotional swings keep reappearing in the charts.
Thirdly, it is also important to understand that that market participants look ahead,
anticipate future events (called discounting), and take action now. If you were standing on railway tracks and saw a train coming, is it likely that you will wait until the last moment before getting off the tracks? No. You would anticipate that the train is going to run you over and you get off the tracks right away.
Market participants do the same. The difference is that not all participants get the news the same time. Some get the news from a different angle, and different people have different attitudes toward the same anticipated developments. For example, if you are an investor and anticipate that some forthcoming bad news will create a short-term reaction in an ongoing up-trend or bull market, you probably would not take any action. On the other hand, if you were a highly leveraged short-term trader (i.e. buying and
selling shares within a 7-day period), you would be foolish not to sell. Otherwise you would stand to lose all your profit.
The sum of the attitude of all participants, and potential participants, is reflected in one thing and one thing only -
the price. This discounting mechanism is the reason that the markets bottom when the news is bad and peak when it is good. At such points of extreme emotional activity, participants have already factored today's headlines into the price and begun to anticipate tomorrow's headlines.
Cycle and Trend Analysis
The technical analyst makes use of various tools during his analysis. Share prices move in a series of peaks and troughs. The direction of those peaks and troughs determine the direction or "cycle trend" of the market. A trend is a time measurement of the direction in price levels covering different time spans. There are many trends, but the three trends that are most widely followed are the primary, secondary or intermediate and minor or short-term trends.
- The Primary or Main Cycle Trend generally lasts between 1 and 2 years and is a reflection of investors' attitudes toward the unfolding fundamentals in the business cycle. The business cycle extends statistically from trough to trough for approximately 3.6 years, so it follows that rising and falling trend cycles (called bull and bear markets) last for 1 to 2 years. Since building up takes longer than pulling down, bull markets generally last longer than bear markets. The primary cycle trend applies for the bond and share market, as well as the commodities market.
- A primary uptrend (bull market) exists as long as each successive high and low is higher than the high and low of the proceeding up-trend, i.e. an up-trend with ascending peaks and troughs or 'higher highs and higher lows'.
- A primary downtrend exists as long as each successive high and low is lower than the high and low of the previous down-trend, i.e. a down-trend with descending peaks and troughs or there are lower highs and lower lows.
When you look at a share price chart, you will notice that prices do not move in a straight line and that the primary cycle trend is interrupted by several reactions along the way. However, because it is important to position investments in the direction of the main trend, a significant part of this tutorial is concerned with identifying reversals in the primary trend.
- The Secondary or Intermediate Cycle Trend is countercyclical trends within the confines of the primary cycle trend. These secondary cycles are more commonly known as 'corrections' within an uptrend and as 'rallies' within a downtrend. They last anywhere from 3 weeks to as long as 6 months or more.
It is important to have an idea of the direction and maturity of the primary trend, but an analysis of the secondary cycle trends is also helpful for improving success in trading, as well as for determining when the primary cycle trend may have run its course.
Most of the time, you will find that the market is either "trending" up or down but you will also find that about a third of the time, that a series of horizontal peaks and troughs would identify a sideways price trend. This type of market is often referred to as "trend-less" or as a trading market.
- The Minor or Short-term Cycle Trends, which last from 1 to 3 or 4 weeks, interrupts the course of the secondary cycle, just as the secondary cycle trend interrupts the primary cycle trend. These minor cycles or daily fluctuations are usually influenced by random news events and are far more difficult to identify than their secondary or primary counterparts. Generally speaking, the longer the time span of the trend, the easier it is to identify.
Support-and-Resistance'>Support and Resistance
The troughs, or reaction lows are called
support. Support is a level or area on the chart under the market where buying interest is sufficiently strong to overcome selling pressure. As a result, a decline is halted and prices turn back up again. Usually a support level is identified beforehand by a previous reaction low.
The diagram above indicates support and resistance levels in an uptrend, as well as in a downtrend. Points labelled with an 'S' are support levels, which are usually previous reaction highs or lows. Points labelled with an 'R' are resistance levels, usually marked by previous peaks or troughs.
- In an uptrend, the resistance levels represent pauses in that up-trend and are usually exceeded at some point. For an up-trend to continue, each successive low (support level) must be higher than the one preceding it.
- In a downtrend, the resistance levels represent pauses in that downtrend and are usually exceeded at some point. For the downtrend to continue, each successive low (support level) must be lower than the one preceding it.
If a 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 a support level is violated, then a trend reversal from up to down is likely. Each time a previous resistance peak is tested, the up-trend is in an especially critical phase. Failure to exceed a previous peak is usually a warning that the existing trend is changing.
Trend lines are one of the most simple, yet effective tools of technical analysis. They are constructed by connecting a series of peaks and troughs.
- Down trend lines connect the highs or peaks; and
- Uptrend lines connect a series of bottoms.
In order to draw a proper trend line, it is first necessary to have two reversal points (peaks or troughs) to connect; otherwise it is a line drawn in space with no technical significance. This is a very important point, since
a trend line represents a dynamic moving area of support or resistance. In effect, a good trend line reflects the underlying trend it is trying to monitor. If the line does not connect the second point it is not a true trend line. As long as the price remains above the trend line, the up-trend is considered to be intact. Once it has been violated, there are two implications for the future course of prices:
- Either the violation represents a trend reversal signal; or
- It indicates a temporary interruption in the prevailing trend.
Trend lines obtain their significance from:
- Length of the trend line - Firstly, the greater the number of points touching on a trend line, the greater its significance i.e. the more the trend line is confirmed. Secondly, the longer the trend line is intact, the greater the importance.
- Minor penetrations - A minor penetration compromises the trend line and you should seek other confirming factors, such as moving averages, etc. as the graph may be about to break the trend and reverse direction. This may mean you stand to lose investment capital.
- Valid penetrations - A valid penetration happens when a share closes above or below its trend line, or you calculate it to be 3% above its trend line.
- Price objectives - Prices usually move a distance beyond the trend line, equal to the vertical distance that prices have achieved on the other side of the line. e.g. if in the prior up-trend, prices moved R5 above the up-trend line (measured vertically), then prices would be expected to drop that same R5 below the trend line after it is broken.
- The angle of ascent or descent of the trend line - The most important trend lines are those that are at a slope of around 45 degrees. Such a line reflects a situation where prices are advancing or declining at such a rate that price and time are in perfect balance. If a trend line is too steep, it won't be long before it is violated and it must be adjusted accordingly. In an accelerated trend, 45 degrees may be too flat, but there are other tools to compensate. Many technicians use 45-degree lines from previous tops or bottoms as major trend lines.
A reversal from an up-trend to a down-trend is usually separated by some volatile trading-range activity in which buyers and sellers experience a closely fought battle. In the up-trend or rally phase, buyers have the upper hand over the sellers, since it is their
enthusiasm that pushes the prices up. During the transitional phase, the enthusiasm of buyers and sellers becomes more balanced as neither is able to dominate over the other. Finally, sellers win and the prices begin a new downtrend.
It is important to note that it is not the number of buyers or sellers that changes, but the
relative balance in their enthusiasm. After all, every purchase must, by definition, be offset by a sale. However, if sellers are fearful, they are more anxious to sell and are more willing to accept a lower price. Conversely, if buyers are greedy, they are desperate to buy and are more willing to pay a higher price.
Over the years, technicians have noticed that these battles are reflected in the charts by clearly identifiable patterns or formations. Understanding what the formations are and their characteristics will either make the investor money or save him money.
Patterns and formations fall into two categories:
- Continuation patterns; and
- Reversal patterns.
Continuation Patterns indicate that the sideways price action on the chart is nothing more than a pause (i.e. consolidation) in the prevailing trend. The next move will be in the direction of that previous trend. It should be noted that continuation patterns are short-to-medium term in nature.
There are a number of recognisable continuation patterns, such as:
- Rectangle Formations;
- Triangle Formations;
- Flags and Pennants, to name a few.
Rectangle Formations - The Rectangle formation clearly demonstrates the temporary balance between buyers and sellers in the transition period. It represents a pause in the trend and they are usually easy to spot on a price chart. In terms of duration, the rectangle formation falls into the one-to-three month category.
The diagram above shows the tail end of a long up-trend or rally, followed by the price moving back and forth in a trading range. The rectangle is constructed by drawing two horizontal lines marking the top (resistance level) and bottom (support level).
The rectangle formation is sometimes also referred to as a trading range or a congestion area. Whatever it is called, it usually represents a period of consolidation in the existing trend, and is usually determined by the direction of the market trend that preceded its occurrence.
A decisive close above or below either the upper or lower support/resistance lines signals completion of the rectangle formation and points the direction of the trend. The technical analyst must always be on the alert, however, that the rectangular consolidation or congestion area does not turn into a reversal pattern, such as a triple top or triple bottom.
Triangle Formations - Triangles are patterns encountered most frequently in technical analysis. Triangles take longer to form than flags or pennants. They generally form over a period of several weeks or a few months and occasionally long-term triangular formations appear. Essentially a triangle indicates uncertainty among investors as to the likely direction of the price trend. Triangles are generally regarded as 'continuation' patterns, which mean that the price is likely to continue in the same direction it moved in before entering the triangle.
There are three types of triangles:
The trend after a triangle is usually the same as that which preceded it. In other words, if the price was moving higher before the triangle formation, it will generally continue moving higher once it has been completed.
Symmetrical Triangles - These are formed by a series of price fluctuations, where each successive up move ends below the previous one and each successive down move ends above the previous one. In other words, the trading range gets progressively narrower or is characterised by a progression of lower peaks and rising troughs. A symmetrical triangle is one that does not lean either up or down.
There comes a point where the price will have to break out of the range and it is here that the price is expected to resume its previous trend. The sharpness of the rise should be intensified if the price breaks out of the triangle between half and three-quarters of the horizontal distance from the base to the apex.
Ascending Triangle (Flat tops) - Ascending or Upward Leaning triangles are similar to the symmetrical triangle, except that the top line of this formation is usually horizontal. The theory behind the ascending triangle is that the top line represents the supply of the share, and the bottom line the demand. If supply remains constant and demand is on the increase, it would not be long before there is a rise in the share price. With the ascending triangle, the buyers are clearly more aggressive than the sellers who could even consist of no more than a single, albeit insignificant, individual participant who is unloading at a fixed price. Ascending triangles are seen as bullish and are more useful patterns for technical analysts because the breakout can be anticipated with a greater degree of reliability.
The Descending Triangle (Flat Bottom) - The descending triangle formation is exactly the opposite to that of the ascending triangle. It therefore follows that the top line represents demand and the bottom line supply. If demand is falling but supply remains the same, it is natural to expect a fall in the share price. With descending triangles, aggressive sellers are causing lower rally peaks and testing the buying power of others who are bidding at a set price. While prices hold at the bottom of the descending triangle, other bidders below the market may become frustrated and unwillingly raise their bids to get an execution. This helps to create a vacuum and, once demand is fulfilled at the floor of the descending triangle, the price will plummet if there are any remaining sellers. Descending or Downward Leaning Triangles are seen as bearish.
Pennants - Pennants must not be confused with triangles. They are preceded by a sharp fall or rise, which makes up the "pole" and are flatter than triangles. Following a sharp rise in price, the up pennant starts forming in a downward slope. Each successive high is lower than the previous one, but each successive low is not necessarily higher than the previous low. As long as the downtrend (resistance) is sharper than the support level, the two lines will eventually meet to form the pennant.
Note that up pennant 'usually' forms in a downward slope. This does not always happen. Sometimes the pennant can 'fly' horizontally, and it can even point slightly in the opposite direction. The down pennant usually slopes
upwards, but can also be horizontal or slightly down-wards. When the pennant is facing the 'wrong' direction (the direction in which the trend was moving), the price will generally not break away. Instead it will move in an accelerating curve. You can therefore expect the price to move higher from an up pennant, which is facing the wrong way, but you will know that a softening in the share price will follow.
Flags - Flags are similar to pennants, with a sudden sharp rise or fall in price, forming the "flag pole". This "pole" is followed by a consolidation phase as the price zigzags up and down in a narrow range (the flag) and finally breaks out. Flags are also seen as "continuation" patterns, i.e. the price continues in the direction it had been going before the flag.
Reversal patterns occur when new developments tip the balance from bullish to bearish and a trend reversal signal is given. This formation is called a reversal formation, because it marks the dividing line between the rising and falling trend. The most common examples of reversal patterns are the Double Top and Double Bottom Formation; Rising and Falling Wedges; Broadening Formations, and the Head and Shoulders Formation.
Double Top and Bottom Formations - A double top is formed when the price bumps up against a resistance level twice and then reacts by falling. This is taken as a strong sell signal, often accompanied by a build-up of volume. A double bottom is just the reverse of the double top and is formed by the price twice bouncing back from a support level to then start rising. It is interpreted as a strong buy signal.
Triple tops and triple bottoms (where the price bounces back three times), are regarded as much stronger buy and sell signals than double tops and bottoms.
Rising and Falling Wedges - Wedges are really another type of triangle with two sides of the triangle both pointing up or down. While normal triangular patterns mostly occur within a fairly short space of time, wedges are generally more drawn out. Unlike triangles, they are seen as "reversal" patterns, i.e. the price is likely to exit from the wedge in the opposite direction from which it had entered.
A rising wedge resembles an ascending triangle with one vital difference. The main selling is not taking place at a precise level, but at gradually higher prices. This suggests that there are more participants selling and, most significantly, indicates a loss of upward momentum. The buyers are unaware of the danger because they are aware of rising lows and fractionally higher highs. A downward sloping wedge is generally bullish and many an upward trend has ended with the completion of a rising wedge formation, which is bearish.
Broadening Formation (Expanding Triangle) - Another type of wedge that often occurs is the widening wedge or broadening formation. Instead of getting narrower towards the end, it widens. This pattern can be seen as a major tug-of-war between investors with opposing opinions or views. One group tries to force the price back to the support or resistance line, which frequently is almost horizontal, while the other group pushes it towards the sloping line and generally wins the battle.
Head and Shoulder Formations - This is the best known and certainly the most notorious of the reliable reversal patterns and provides the basic blueprint for the majority of all reversal patterns. These patterns occur as reversals, both up and down, and as continuation or consolidation patterns. They manifest themselves in the shape of three well-defined peaks, where the middle peak is more pronounced than the two outside peaks - creating an image of a head flanked by two shoulders - hence the name. It is possible to construct a trend line joining the low of the left shoulder and the head. This is known as the neckline.
The pattern consists of a "left shoulder" which is formed by
investors perceiving a buying opportunity and buying shares, which pushed up the price (left shoulder). However, there is quite a lot of selling pressure because it is near the end of a bull phase and the run-up in the price is short and the price drops. Then comes the "head" which is formed by another higher price rise and a further drop, which takes the price down to somewhere close to the previous low. This is caused when the price has fallen sufficiently for investors (including those who missed out on the first run) to again perceive a good buying opportunity and this pushes the share price up again, forming the "head". After a while the buying pressure abates and the price drops again. It could be slightly above or slightly below the previous low but must be below the top of the left shoulder.
This is followed by the formation of the "right shoulder". This is formed by some investors seeing a buying opportunity even now, causing a further brief price rise (not as high as the "head") and a further drop to below the level of the "neck line", formed by connecting the bottoms between the head and the two shoulders. This neckline effectively forms a support level connecting previous lows. You could then measure the distance between the head and the neckline and then project that same distance from the breakout to estimate the downside. It is very important to wait for a decisive break below the neckline.
The head and shoulders pattern generally heralds the end of a bull phase and the beginning of a bear phase in the market. The head and shoulders pattern can also be found in an inverted form and in this case signify an upward reversal in the share price. Head and shoulders reversal patterns abound and are varied in shape, length of time to resolve, in price breakout objective and sometimes even in signalling the continuance of the trend prior to the Head and Shoulders as a consolidation pattern (as opposed to a reversal pattern). Generally speaking, the longer the period, the greater the amount of distribution that has taken place and therefore the longer the ensuing bear trend is likely to be. The larger head and shoulders formations are often very complex and comprise several smaller ones.
Volume in Chart Patterns
The volume pattern should generally increase in the direction of the market trend and is an important confirming factor in the completion of all chart patterns. The completion of each pattern should be accompanied by a noticeable increase in volume. The volume pattern with most price chart patterns is very similar in that volume diminishes as the pattern works itself out and then increases on the breakout. The technical analyst can detect slight shifts in the volume pattern coinciding with the swings in the price action.
- When the price is rising within a formation, volume tends to be slightly heavier on bounces and lighter on dips. Volume is usually more important on the upside.
- When the price is falling, volume should be heavier on the downside and lighter on the bounces. For example, in the head and shoulders reversal pattern, volume is normally high at the bottom of the 'left shoulder' and during the formation of the 'head'. The major factor to watch for is volume activity on the 'right shoulder', which should fall during the decline to the trough and expand substantially on the breakout.
Arithmetic versus Logarithmic scaling
There are two types of vertical price scales that are used in share market charting:
Arithmetic Scaling - In the arithmetic type scale, all vertical subdivisions (squares) are of equal size. Assuming we prescribe a value of 10c to each square, a rise from 10c to 20c will produce a change in the line on the chart equivalent to one block. In the same way a rise in price from 100c to 110c will produce an equivalent change. Unfortunately, use of arithmetic scaling can give rise to a distorted picture, Percentage-wise, the rise in price from 5c to 10c representing a 100% change, whereas the rise from 100c to 110c represents only a 10% change. After a prolonged move in one direction the line may pass right off the page!
Logarithmic Scaling - In logarithmic scaling, the vertical height of the blocks reduces progressively as one proceeds up the vertical scale. This scaling serves to counteract the distortion encountered with arithmetic scaling. Using logarithmic scales, a rise in price from 10c to 20c will produce the same change as a rise from 100c to 200c. Considering that both movements represent a 100% increase in price this is an accurate percentage-wise projection. However, certain problems do surface when using logarithmic scale for point and figure charts. For some types of analysis, particularly for very long-ranged trend analysis, there may be some advantages to using logarithmic scaling.
Although technical analysis is not concerned with the reasons behind a price movement, there is always a reason. Even though it may sometimes be trivial like an unexpected note of caution in the chairman's report when the figures are announced or more drastic reasons such as a profit warning, you should be prompted to find out why market sentiment has forced the price down. Because it is unexpected, it is frequently the case that the market has over reacted which pushes the price down much further than may be justified. When this occurs, it is really just a matter of having some common sense and a feel of where the right price should be and you can find a buying opportunity. The share market can be very volatile at times, and it has the tendency to behave like a pendulum and swing too far in either direction. Charts and the technical analysis software will help you to identify such events but it is essential that when such a swing occurs that you still do your fundamental analysis homework, as well as to apply risk management strategies (to be discussed in a latter tutorial).
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