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Earlier, we established that technical analysis is the art of identifying a (price) trend reversal based on the weight of the evidence. As in a court of law, a trend is presumed innocent until proven guilty! The “evidence” is the objective element in technical analysis. It consists of a series of scientifically derived indicators or techniques that work well most of the time in the trend-identification process.
Technical Analysis Explained PDF Book by Martin J. Pring
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The “art” consists of combining these indiÂ cators into an overall picture and recognizing when that picture resembles a market peak or trough. Widespread use of computers has led to the development of some very sophisticated trend-identification techniques. Some of them work reasonably well, but most do not.
The continual search for the “Holy Grail,” or perfect indicator, will undoubtedly continue, but it is unlikely that such a technique will ever be developed. Even if it were, news of its discovery would soon be disseminated and the indicator would gradually be discounted. It is as well to remember that prices are determined by swings in crowd psychology. People can and do change their minds, and so do markets!
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Rhea defined a line as “a price movement two to three weeks or longer, during which period, the price variation of both averages moves within a range of approximately 5 percent (of their mean average). I see no reason why the 5 percent rule cannot be exceeded. After all, it really represents a digestion of gains or losses or a pause in the trend.
Such a movement indicates either accumulation [stock moving into strong and knowledgeable hands and therefore bullish or distribution [stock moving into weak hands and therefore bearish].”4 An advance above the limits of the “line” indicates accumulation and predicts higher prices, and vice versa.
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When a line occurs in the middle of a primary advance, it is really forming a horizontal secondary movement and should be treated as such. My own view is that the formation of a legitimate line should probably take longer than 2 to 3 weeks. After all, a line is really a substitute for an intermediate price trend and 2 to 3 weeks is the time for a short-term or minor price movement.
We have already established that previous highs and lows are potential support or resistance levels. Highs are important because many market participants may have bought close to or at the actual high for a move. When prices decline, the normal human response is not to take a loss, but to hold on. That way, the pain of actually realizing a loss can be avoided.
As a result, when the price returns to the old high, those who bought at that level have great motivation to sell in order to break even. Consequently, they liquidate. Also, those who bought at lower prices have a tendency to take profits at the old high, since that is the top of familiar ground. Technical Analysis Explained PDF Book
By the same token, any prices above the old high look expensive to potential buyers; consequently, there is less enthusiasm on their part, so they begin to pull away from the market. When a price rallies and then falls back to the previous low, these bargain-basement prices appeal to potential buyers.
After all, they missed the opportunity the first time prices retreated to this level, and they are therefore thankful to have another chance. For the same reason, sellers are reluctant to part with their securities as prices approach the previous low, since they saw them bounce before and naturally wonder why the same process should not be repeated.
Chart 5.1 shows the sugar price for a period spanning 2002–2003. Note how previous highs and lows offer good support/resistance points for future trading. Unfortunately, there is no way of knowing whether a particular level will turn out to be support or resistance, or even whether it will be a pivotal point at all. Technical Analysis Explained PDF Book
That’s why these are merely intelligent places for anticipating a temporary reversal. Resort to other indicators such as oscillators is therefore required. The calculation of the directional movement system is quite involved, and time does not permit a full discussion here. For that readers are referred to Wilder’s New Concepts in Technical Trading Systems (Trend Research, 1978.
To my own Definitive Guide to Momentum Indicators book and CDROM tutorial (Marketplace Books, 2009), or to my online audio-visual technical analysis course at Pring.com. To simplify matters, the directional movement indicator is plotted by calculating the maximum range that the price has moved, either during the period under consideration (day, week, 10-minute bar, etc.) or from the previous period’s close to the extreme point reached during the period.
In effect, the system tries to measure directional movement. Since there are two directions in which prices can move, there are two directional movement indicators. They are called +DI and -DI. The resultant series is unduly volatile, so each is calculated as an average over a specific time period and then plotted. Normally, these series are overlaid in the same chart panel, as shown in Chart 15.21 for the euro using the standard, or default, time span of 14 periods. Technical Analysis Explained PDF Book
The three black crows pattern (Figure 16.23) consists of three declining black candlesticks, which form after an advance and indicate lower prices. Each candlestick should close at or near its session low. You can see that none of them have a lower wick and each of the three real bodies opens within the range or right at the bottom of the previous session’s real body.
A good example is featured in Chart 16.7 for Aseer Trading, Tourism and Manufacturing, a Middle Eastern stock. The first crow was a kind of shooting star, which in itself suggested that buyers had spent all their investment funds. There is a tendency among many technicians to look at candlesticks in isolation.
My preference, remembering the weight-of-the-evidence approach discussed earlier, is to combine selected Western charting techniques with candlesticks. This involves, among other things, the inclusion of price patterns, trendlines, and oscillators into the analysis. Chart 16.8 for instance, shows a head-and-shoulders top for Microsoft that was completed in November 2000. Technical Analysis Explained PDF Book Download
Note that the sell-off during the right shoulder was an identical three-crow pattern. Later on, we see a double bottom. The rally from the second low consisted of a bullish belt hold, which in itself indicated that prices were headed higher. This bottom was also associated with a reverse head and shoulders in the relative strength indicator (RSI).
Finally, the head-and-shoulders top in the RSI was confirmed with a harami. One important question concerns where to draw the trendlines. Should they touch the wicks, real bodies, or a combination of both? Fibonacci fan lines are displayed by first drawing a line between two extreme points: a high and low (vice versa in a declining market). An invisible vertical line is drawn through the second extreme point.
Three lines are then constructed from the first extreme point (the low) passing through the invisible vertical line with their slopes at the Fibonacci levels, usually 38.2 percent, 50.0 percent, and 61.8 percent. These lines indicate potential areas of support and resistance. An RS line is obtained by dividing the price of one item by another. Technical Analysis Explained PDF Book Download
The numerator is usually a stock, and the denominator a measurement of “the market,” for example, the NASDAQ or the S&P 500. Outside the US it would be a stock price compared to a specific country average such as the DAX in Germany, the Nifty in India and so forth. In later chapters we will also look at the relative relationships between sectors and industry groups against the market, as this represents a shortcut method of stock selection.
For example, it is quicker to study the RS lines for 12 sectors and then study the components of the selected area than to review 3,000 to 5,000 individual stocks. The relative strength concept can also be expanded to the commodity area. This is achieved by comparing the price of an individual commodity, such as corn, to a commodity index, such as the Thompson Reuters Commodity Research Board (CRB) Composite or the Dow Jones UBS Commodity Index.
Our examples will focus on individual stocks relative to the market, but this and other concepts are equally acceptable. In this respect, Figure 19.1 shows the closing price of the stock in the upper panel and its RS in the lower one. RS is widely used in the futures markets under the heading “spread trading,” in which market participants try to take advantage of market distortions. Technical Analysis Explained PDF Book Download
These discrepancies arise because of unusual fundamental developments that temporarily affect normal relationships. Spreads are often calculated by subtracting the numerator from the denominator rather than dividing. I prefer the division method because it presents the idea of proportionality. However, if a spread is calculated over a relatively short period (for example, less than 6 months), it is not important whether subtraction or division is used.
In previous editions, our central theme focused on technical principles, with a primary objective of analyzing the U.S. stock market. In the early 1980s, when the United States was far more dominant in the global financial scene, that approach had some merit. In the second decade of the twenty-first century and beyond, the attention of technicians has become far more diverse, having broadened to international stock markets, bonds, commodities, and currencies.
While our coverage will be broadened in this edition, it is not possible to cover all of the market averages and indexes that have been developed for these various entities in one small chapter. Another important financial market development in the twentyfirst century has been the rapid expansion and burgeoning popularity of exchange-traded funds (ETFs) and, to a lesser extent, exchange-traded notes (ETNs). Technical Analysis Explained PDF Book Free
Previously, the purchase of an index involved the acquisition of its individual components, but with ETFs, it was now possible to buy the index just like a stock. That’s because the ETF is a basket of stocks whose management objective is to replicate a stated index. To give you an idea of their growth,
I stated in my book The Investor’s Guide to Active Asset Allocation (McGraw-Hill, 2006) that there were then 160 listed ETFs. In mid-2013, that number was closer to 1,500 and still growing. One personally important introduction was the Pring Turner Business Cycle ETF, in December 2012 (symbol DBIZ).
The fund adopts an active approach based on the business cycle and technical strategies outlined in this book. The system continued to work extremely well, as you can see by looking back at the equity line in the upper panel in Chart 34.8. However, I am glad I used the cautionary statement, because once we move past 1993, the system fell apart. Just look at the declining equity line between 1993 and 2002 in Chart 34.8. Indeed, though it made money for the next 10 years, the peak 1993 equity has never been surpassed. Technical Analysis Explained PDF Book Free
The initial drop was due to the many whipsaws arising from the trading range that followed the drop from $2.00 in 1993. This goes to show that even if a system works well for 20 years, as this one had, market conditions can and do change, so you must be prepared for such instances. Obviously, we do not know until sometime after the fact that the market environment was different. Is there anything we can do to avoid such situations? One possibility is to run a very long-term MA or trendline through the equity line.
Finally, the inverted yield falls below its average in early 1987 (D). The market continues to rally, but the system is no longer bullish. In most instances, it would be better to generate the sell signals after the S&P crosses below its average. In this instance, though, the 1987 crash was over before the average was penetrated.
Since the risk increases as the money-market series crosses below its average, it is probably best to act on the signal in two parts. This would involve taking off half the position as the money-market series goes negative and then liquidating the rest when the S&P crosses its average. Figure 34.5 compares the risk and reward for the system between 1900 and 2009 to that for the S&P Composite. Technical Analysis Explained PDF Book Free
If you are a short-term trader, you probably feel this approach is worse than useless. However, it can be put to very good use if you realize that when the system is bullish, short sell signals are more likely to result in losses. They are not just going against the main trend, but are occurring in one of the most positive equity environments you can get.