12. MOVING AVERAGES

In the realm of technical indicators, moving averages are extremely popular with market technicians and with good reason.Moving averages smooth the price action and make it easier to spot the underlying trends. Precise trend signals can be obtained from the interaction between a price and an average or between two or more averages themselves. Since the moving average is constructed by averaging several days’ closing prices, however, it tends to lag behind the price action.The shorter the average (meaning the fewer days used in its calculation), the more sensitive it is to price changes and the closer it trails the price action. A longer average (with more days included in its calculation) tracks the price action from a greater distance and is less responsive to trend changes. The moving average is easily quantified and lends itself especially well to historical testing.Mainly for those reasons,it is the mainstay of most mechanical trend-following systems.

Popular Moving Averages
In stock market analysis, the most popular moving average lengths are 50 and 200 days. [On weekly charts, those daily values are converted into 10 and 40-week averages.] During an uptrend, prices should stay above the 50-day average. Minor pullbacks often bounce off that average, which acts as a sup-port level.A decisive close beneath the 50-day average is usually one of the first signs that a stock is entering a more severe
correction. In many cases, the breaking of the 50-day average signals a further decline down to the 200-day average. If a market is in a normal bull market correction,it should find new support around its 200-day average. [For short-term trading purposes, traders will employ a 20-day average to spot short-term
trend changes].

Bollinger Bands
These are trading bands plotted two standard deviations above and below a 20-day moving average. When a market touches (or exceeds) one of the trading bands, the market is considered to be over-extended. Prices will often pull back to the moving average line.

Moving Average Convergence Divergence (MACD)
The MACD is a popular trading system. On your computer screen, you’ll see two weighted moving averages (weighted moving averages give greater weight to the more recent price action).Trading signals are given when the two lines cross.

11. USING A TOP-DOWN MARKET APPROACH

The idea of beginning one’s analysis with a broader view and gradually narrowing one’s focus has another important application in the field of market analysis.That has to do with utilizing a “top-down” approach to analyzing the stock market. This approach utilizes a three-step approach to finding winning stocks. It starts with an overall market view to determine whether the stock market is moving up or down, and whether this is a good time to be investing in the market. It then breaks the stock market down into market sectors and industry groups to determine which parts of the stock market look the strongest. Finally, it seeks out leading stocks in those leading sectors and groups. 


THE FIRST STEP: The Major Market Averages
The intent of the first step in the “top-down” approach is to determine the trend of the overall market. The presence of a bull market (a rising trend) is considered a good time to invest funds in the stock market. The presence of a bear market (a falling trend) might suggest a more cautious approach to the stock market. In the past, it was possible to look at one of several major market averages to gauge the market’s trend. That was because most major averages usually trended in the same direction. That hasn’t always been the case in recent history however. For that reason, it’s important to have some familiarity with the major market averages, and to know what each one actually measures.


Different Averages Measure Different Things
The traditional blue chip averages—like the Dow Jones Industrial Average, the NYSE Composite Index, and the S&P 500—generally give the best measure of the major market trend.The Nasdaq Composite Index,by contrast, is heavily influenced by technology stocks.While the Nasdaq is a good barometer of trends in the technology sector, it’s less useful as a measure of the overall market trend.The Russell 2000 Index measures the performance of smaller stocks. For that reason, it’s used mainly to gauge the performance of that sector of the market. The Russell is less useful as a measure of the broader market which is comprised of larger stocks. Since most of these market averages are readily available in the financial press and on the Internet,it’s usually a good idea to keep an eye on all of them.The strongest signals about market directions are given when all or most of the major market averages are trending in the same direction (See Figure 11-1).


THE SECOND STEP: Sectors and Industry Groups
The stock market is divided into market sectors which are subdivided further into industry groups. There are ten market sectors, which include Basic Materials, Consumer Cyclicals,
Consumer Non-Cyclicals, Energy, Financial, Healthcare, Industrial, Technology, Telecommunications, and Utilities. Each of those sectors can have as many as a dozen or more industry groups. For example, some groups in the Technology sector are

Computers, the Internet, Networkers, Office Equipment, and Semiconductors. The Financial sector includes Banks, Insurance, and Securities Brokers. The recommended way to approach this group is to start with the smaller number of market sectors. Look for the ones that seem to be the strongest.During most of 1999 and into the early part of 2000, for example, technology stocks represented the strongest market sector. Once you’ve isolated the preferred sector, you can then look for the strongest industry groups in that sector.Two leading candidates during the period of time just described were Internet and Semiconductor stocks. The idea is to be in the strongest industry groups within the strongest market sectors (See Figure 11-2). For many investors, the search can stop there.The choice to be in a market sector or industry group can easily be imple-

mented through the use of mutual funds that specialize in specific market sectors or industry groups.


THE THIRD STEP: Individual Stocks
For those investors who deal in individual stocks, this is the third step in the “top-down”market approach. Having isolated an industry group that has strong upside potential, the trader can then look within that group for winning stocks. It’s been estimated that as much as 50% of a stock’s direction is determined by the direction of its industry group. If you’ve already found a winning group, your work is half done. Another advantage of limiting your stock search to winning sectors and groups is that it narrows the search considerably.
There are as many as 5,000 stocks that an investor can choose from. It’s pretty tough doing a market analysis of so many mar-

kets.Some sort of screening process is required.That’s where the three-step process comes in.By narrowing your stock search to a small number of industry groups, the number of stocks you have to study is dramatically reduced.You also have the added comfort of knowing that each stock you look at is already part of a winning group (See Figure 11-3).

10. USING DIFFERENT TIME FRAMES FOR SHORT- AND LONG-TERM VIEWS

Bar chart analysis is not limited to daily bar charts.Weekly and monthly charts provide a valuable long-term perspective on market history that cannot be obtained by using daily charts alone.The daily bar chart usually shows up to twelve months of price history for each market.Weekly charts show almost five years of data, while the monthly charts go
back over 20 years (See Figure 10-1).


By studying these charts,the chartist gets a better idea of longterm trends,where historic support and resistance levels are located, and is able to obtain a clearer perspective on the more recent action revealed in the daily charts. These weekly and monthly charts lend themselves quite well to standard chart analysis described in the preceding pages. The view held by some market observers that chart analysis is useful only for short-term analysis and timing is simply not true.The principles of chart analysis can be used in any time dimension.


Using Intraday Charts


Daily and weekly charts are useful for intermediate- and longterm analysis. For short-term trading, however, intraday charts 

are extremely valuable. Intraday charts usually show only a few days of trading activity. A 15-minute bar chart, for example, might show only three or four days of trading.A 1-minute or a 5-minute chart usually shows only one or two days of trading respectively, and is generally used for day-trading purposes. Fortunately, all of the chart principles described herein can also be applied to intraday charts (See Figure 10-2).



Going From the Long Term to the Short Term


As indispensable as the daily bar charts are to market timing and analysis, a thorough chart analysis should begin with the monthly and weekly charts—and in that order.The purpose of
that approach is to provide the analyst with the necessary longterm view as a starting point. Once that is obtained on the 20-year monthly chart, the 5-year weekly chart should be consult-

ed.Only then should the daily chart be studied. In other words, the proper order to follow is to begin with a solid overview and then gradually shorten the time horizon. (For even more microscopic market analysis, the study of the daily chart can be followed by the scrutiny of intraday charts.)

9. THE INTERPRETATION OF VOLUME

Chartists employ a two-dimensional approach to market analysis that includes a study of price and volume. Of the two,price is the more important.However,volume provides important secondary confirmation of the price action on the chart and often gives advance warning of an impending shift in trend (See Figure 9-1).


Volume is the number of units traded during a given time period,which is usually a day.It is the number of common stock shares traded each day in the stock market.Volume can also be
monitored on a weekly basis for longer-range analysis.


When used in conjunction with the price action,volume tells us something about the strength or weakness of the current price trend.Volume measures the pressure behind a given price
move. As a rule, heavier volume (marked by larger vertical bars at the bottom of the chart) should be present in the direction of the prevailing price trend. During an uptrend, heavier
volume should be seen during rallies, with lighter volume (smaller volume bars) during downside corrections. In downtrends, the heavier volume should occur on price selloffs. Bear
market bounces should take place on a lighter volume.

Volume Is an Important Part of Price Patterns

Volume also plays an important role in the formation and resolution 

of price patterns. Each of the price patterns described 

previously has its own volume pattern.As a rule, volume tends

to diminish as price patterns form.The subsequent breakout that 

resolves the pattern takes on added significance if the price 

breakout is accompanied by heavier volume. Heavier volume 

accompanying the breaking of trendlines and support or resistance 

levels lends greater weight to price activity (See Figure 9-2).

On-Balance Volume (OBV)

Market analysts have several indicators to measure trading 

volume. One of the simplest, and most effect, is on-balance volume 

OBV). OBV plots a running cumulative total of upside ver-

sus downside volume.Each day that a market closes higher, that 

day’s volume is added to the previous total. On each down day, 

the volume is subtracted from the total. Over time, the on-balance 

volume will start to trend upward or downward. If it 

trends upward, that tells the trader that there’s more upside 

than downside volume, which is a good sign.A falling OBV line

is usually a bearish sign.


Plotting OBV

The OBV line is usually plotted along the bottom of the price 

chart. The idea is to make sure the price line and the OBV line 

are trending in the same direction. If prices are rising, but the

OBV line is flat or falling, that means there may not be enough 

volume to support higher prices. In that case, the divergence 

between a rising price line and a flat or falling OBV line is a negative 

warning (See Figure 9-3).

OBV Breakouts

During periods of sideways price movement, when the market 

trend is in doubt, the OBV line will sometimes break out 

first and give an early hint of future price direction.An upside

breakout in the OBV line should catch the trader’s eye and 

cause him or her to take a closer look at the market or stock in 

question.At market bottoms, an upside breakout in on-balance

volume is sometimes an early warning of an emerging uptrend 

(See Figure 9-4).

Other Volume Indicators

There are many other indicators that measure the trend of 

volume—with names like Accumulation Distribution, Chaikin 

Oscillator, Market Facilitation Index, and Money Flow. While

they’re more complex in their calculations, they all have the
same intent —to determine if the volume trend is confirming,
or diverging from, the price trend.

8. PERCENTAGE RETRACEMENTS

Market trends seldom take place in straight lines.Most trend pictures show a series of zig-zags with several corrections against the existing trend.These corrections usually fall into certain predictable percentage parameters. The best-known example of this is the fifty-percent retracement. That is to say, a secondary, or intermediate, correction against a major uptrend often retraces about half of the prior uptrend before the bull trend is again resumed. Bear market bounces often recover about half of the prior downtrend.


A minimum retracement is usually about a third of the prior trend. The two-thirds point is considered the maximum retracement that is allowed if the prior trend is going to resume. A retracement beyond the two-thirds point usually warns of a trend reversal in progress. Chartists also place importance on retracements of 38% and 62% which are called Fibonacci retracements.

7. THE KEY REVERSAL DAY

Another price formation is the key reversal day. This minor pattern often warns of an impending change in trend. In an uptrend, prices usually open higher, then break sharply to the downside and close below the previous day’s closing price. (A bottom reversal day opens lower and closes higher.)

The wider the day’s range and the heavier the volume, the more significant the warning becomes and the more authority it carries. Outside reversal days (where the high and low of the current day’s range are both wider than the previous day’s range) are considered more potent.The key reversal day is a relatively minor pattern taken on its own merits, but can assume major importance if other technical factors suggest that an important change in trend is imminent (See Figure 7-1).

6. PRICE GAP

Gaps are simply areas on the bar chart where no trading has taken place.An upward gap occurs when the lowest price for one day is higher than the highest price of the preceding day. A downward gap means that the highest price for one day is lower than the lowest price of the preceding day.There are different types of gaps that appear at different stages of the trend. Being able to distinguish among them can provide useful and profitable market insights.Three types of gaps have forecasting value—breakaway, runaway and exhaustion gaps (See Figure 6-1).


The breakaway gap usually occurs upon completion of an important price pattern and signals a significant market move. A breakout above the neckline of a head and shoulders bottom, for example, often occurs on a breakaway gap.

The exhaustion gap occurs right at the end of the market move and represents a last gasp in the trend. Sometimes an exhaustion gap is followed within a few days by a breakaway gap in the other direction, leaving several days of price action isolated by two gaps. This market phenomenon is called the island reversal and usually signals an important market turn. The runaway gap usually occurs after the trend is well underway. It often appears about halfway through the move (which is why it is also called a measuring gap since it gives some indication of how much of the move is left.) During uptrends,the breakaway and runaway gaps usually provide support below the market on subsequent market dips; during downtrends, these two gaps act as resistance over the market on bounces.

5. REVERSAL AND CONTINUATION PRICE PATTERNS

One of the more useful features of chart analysis is the presence of price patterns, which can be classified into different categories and which have predictive value.These patterns reveal the ongoing struggle between the forces of supply and demand, as seen in the relationship between the various support and resistance levels, and allow the chart reader to gauge which side is winning. Price patterns are broken down into two groups—reversal and continuation patterns. Reversal patterns usually indicate that a trend reversal is taking place. Continuation patterns usually represent temporary pauses in the existing trend.Continuation patterns
take less time to form than reversal patterns and usually result in resumption of the original trend.


REVERSAL PATTERNS


The Head and Shoulders
The head and shoulders is the best known and probably the most reliable of the reversal patterns.A head and shoulders top is characterized by three prominent market peaks.The middle

peak, or the head, is higher than the two surrounding peaks (the shoulders). A trendline (the neckline) is drawn below the two intervening reaction lows.A close below the neckline completes the pattern and signals an important market reversal (See Figure 5-1).


Price objectives or targets can be determined by measuring the shapes of the various price patterns.The measuring technique in a topping pattern is to measure the vertical distance from the top of the head to the neckline and to project the distance downward from the point where the neckline is broken.The head and shoulders bottom is the same as the top except that it is turned upside down.


Double and Triple Tops and Bottoms
Another one of the reversal patterns, the triple top or bottom, is a variation of the head and shoulders.The only difference is

that the three peaks or troughs in this pattern occur at about the same level. Triple tops or bottoms and the head and shoulders reversal pattern are interpreted in similar fashion and mean essentially the same thing.
Double tops and bottoms (also called M’s and W’s because of their shape) show two prominent peaks or troughs instead of three. A double top is identified by two prominent peaks. The inability of the second peak to move above the first peak is the first sign of weakness. When prices then decline and move under the middle trough, the double top is completed. The measuring technique for the double top is also based on
the height of the pattern. The height of the pattern is measured and projected downward from the point where the trough is broken. The double bottom is the mirror image of the top (See Figures 5-2 and 5-3).

Saucers and Spikes
These two patterns aren’t as common, but are seen enough to warrant discussion.The spike top (also called a V-reversal) pictures a sudden change in trend. What distinguishes the spike from the other reversal patterns is the absence of a transition period,which is sideways price action on the chart constituting topping or bottoming activity. This type of pattern marks a dramatic change in trend with little or no warning (See Figure 5-4).


The saucer, by contrast, reveals an unusually slow shift in trend.Most often seen at bottoms,the saucer pattern represents a slow and more gradual change in trend from down to up.The chart picture resembles a saucer or rounding bottom—hence its name (See Figure 5-5).

CONTINUATION PATTERNS




Triangles
Instead of warning of market reversals, continuation patterns are usually resolved in the direction of the original trend.Triangles are among the most reliable of the continuation patterns. There are three types of triangles that have forecasting value—symmetrical, ascending and descending triangles. Although these patterns sometimes mark price reversals, they usually just represent pauses in the prevailing trend. The symmetrical triangle (also called the coil) is distinguished by sideways activity with prices fluctuating between two converging trendlines.The upper line is declining and the lower line is rising. Such a pattern describes a situation where buying and selling pressure are in balance. Somewhere between the half-way and the three-quarters point in the pattern, measured in calendar time from the left of the pattern to the point where the two lines meet at the right (the apex), the pattern should be resolved by a breakout. In other words, prices will close beyond one of the two converging trendlines (See Figure 5-6).


The ascending triangle has a flat upper line and a rising lower line. Since buyers are more aggressive than sellers, this is usually a bullish pattern (See Figure 5-7). The descending triangle has a declining upper line and a flat lower line. Since sellers are more aggressive than buyers, this is usually a bearish pattern. The measuring technique for all three triangles is the same. Measure the height of the triangle at the widest point to the left of the pattern and measure that vertical distance from the point

where either trendline is broken. While the ascending and descending triangles have a built-in bias,the symmetrical triangle is inherently neutral. Since it is usually a continuation pattern,however, the symmetrical triangle does have forecasting value and implies that the prior trend will be resumed. Flags and Pennants These two short-term continuation patterns mark brief pauses, or resting periods, during dynamic market trends. Both are usually preceded by a steep price move (called the pole). In an uptrend, the steep advance pauses to catch its breath and moves sideways for two or three weeks.Then the uptrend continues on its way.The names aptly describe their appearance. The pennant is usually horizontal with two converging trend-

lines (like a small symmetrical triangle). The flag resembles a parallelogram that tends to slope against the trend. In an uptrend, therefore, the bull flag has a downward slope; in a downtrend, the bear flag slopes upward. Both patterns are said to “fly at half mast,”meaning that they often occur near the middle of the trend,marking the halfway point in the market move (See Figures 5-8 and 5-9).


In addition to price patterns, there are several other formations that show up on the price charts and that provide the chartist with valuable insights. Among those formations are price gaps, key reversal days, and percentage retracements.