The cornerstones to technical studies

Over
the past few sections, we have done with identification of a trend and
how they can be grouped together for study. We looked further at the
concept of support and how they are formed and also have a role
reversal phenomenon, which makes it useful for trading.

We now
move further down the learning curve and take up the simplest of our
set of tools within Technical Analysis – the Trend line. Once a trend
is discernible then trend lines can be drawn to define the lower limits
of an up trend or the upper limits of a downtrend. At its most basic
level, we form trend lines by joining two lows in a rising trend
(support trend line) or by joining two highs in a declining trend
(resistance trend line). It is essential that trend lines are drawn
correctly. It is the recognition of the trend line and the violation of
this trend line that is your key to successful trading and fortune
building. The correct trend line for the given time context is :

Sometimes
this cannot be done. Prices hardly ever rise or fall at a constant
rate. At such times it should be realized that the second point (i.e.
the last minor low or the last minor high) is the fixed one and we can
move the first point (i.e. the point at the lowest low or the highest
high) to a level where all the trading bars lie above or below, as the
case may be, the trend line.

This was a
technique popularized by W.D.Gann who drew 45 degree angle lines from a
significant low (upward) or high (downward) and used these as support
or resistance lines. The advantage of this over the traditional form of
trend line is that these lines can be drawn from just one data point
and one need not wait for the second point (either support or
resistance) to form. There are considerations such as the scaling which
will change the slope of the angle. Gann has described a specific way
of locking the scaling to the time unit so that the slope of the angle
will remain the same. The interpretation of trend line by angle remains
the same as the normal trend line.

Trendlines
function mainly to define supports (in a rising market) and to
resistance (in a falling market). Stocks in a trend are expected to
persist with the same trend until the trendline is penetrated or
broken. Depending upon which time frame chart is used to plot prices,
the trendlines are labeled as short term trendline or medium term or
long term trendlines. The break of a long term trendline is to be
treated as much more significant development as compared to a the break
of a short term trendline.

During development of a
trend the growth of the trend proceeds at different rates at different
times. A frequent sequence is the following – a short initial explosive
breakout and advance from a previous prolonged period of range trading,
a much longer period of steady progression at a lower rate of change
and, finally, a shorter period of noticeably slower rate of progression.

Each
phase of trend advancement is followed by a period of retracement and
consolidation. The initial growth phase is too rapid to be sustained
and the ensuing correction is often quite deep. The second phase of
advancement is one of steady sustainable growth and often persists for
some time. Inevitably this too ends and a period of retracement follows
but usually not as deep as the initial correction. This second
correction often takes more time than the first to complete the
corrective process. When the correction is complete the final phase of
trend advancement occurs usually at the slowest rate of change for the
whole progression of the trend and then this too corrects.

The
three trend lines that can be drawn from the initial point of the trend
through each of the retracement extremes are known as Fan Lines. They
illustrate the decaying rate of progress of the trend. When finally
prices violate the third fan line it invariably means the trend so
monitored has finished and a reversal of the trend is underway.

We have
looked at the underlying psychology of the market, the constant
struggle between buyers and sellers and the necessary participation of
the uncommitted to break deadlock and initiate or propagate trends. We
then defined trend and emphasized the importance of drawing correct
trend lines within the context of the time frame in which you have a
trading interest. Now we will combine these insights to maximize the
efficiency of trading. This we will do by establishing channels about
the trend. We will also very briefly broaden the concept of channels to
the concept of bands. We will in the future discuss in detail specific
band creation and use when we deal with the underlying technical
modality.

We learned earlier that the trend line acts as
underlying support to up trend lines and overhead resistance to down
trends. We also can observe that prices once finding support
(resistance) will move ahead and away from the trend line then return
to the trend line. Over time we can recognize that this meandering
course of price movements to and from the trend line form a channel of
variance from the trend line and in the direction of the trend.

Remember
the market is made up of people, ordinary folk with all the human gifts
and frailties. There are buyers who are committed in varying degree to
prices going up, sellers who are similarly convinced that prices are
headed down and that that large undefined mass of the uncommitted,
observing the buyer/seller dynamic turmoil and joining the fray when
they are convinced that one or the other is in ascendancy.

In
an up trend, as prices reach the up trend line, new increased buying
comes into the market in such strength as to overwhelm the selling of
the sellers. These buyers are made up of previous buyers in the market
adding to their positions, intending buyers who missed earlier
opportunities and are now buying the dip. Previous sellers who didn’t
cover their short positions on the last price rise are now sufficiently
encouraged that they are, and have been, right all along, nervously
leave their short positions on and so their effect at this point is
neutral. The buying that aborts selling at the trend line impress some
of the previously uncommitted now convinced that the buyers have the
upper hand, buy. This new buying takes prices up and away from the
trend line and the further it moves up the more impressed the
uncommitted become and more buyers come into the market, and more of
the previous short sellers become frustrated and buy to cover their
short positions and prices move up further. After a while buying
becomes exhausted and is overwhelmed by selling by profit taking
previous buyers and new short sellers who are selling the strength on
what they perceive to be a selling opportunity. As buying is
overwhelmed more profit taking occurs and nervous recent buyers will
have their close trailing stops triggered as market orders and so
prices retreat to the trend line again when the whole cycle starts off
again if the up trend is to continue. This to and fro, buying and
selling in the direction of the trend plots out a recognizable channel
of dynamic flux of the trend.

Recognizing the trend line and
the opposing parallel channel line – channel return line – and
understanding the human dynamics that account for its structure we can
increase the efficiency of profit making by initiating or adding to
one’s position at trend lines and profit taking at the channel return
line. One can trade the retracement. For those who do not wish to trade
the trend so aggressively one can use the trend line for placing and
moving stops. Recognizing the violation of the trend line and when to
initiate trades in response to trend violation, one can have a
recognizable entry level to trade the new trend. Also, as the trend
progresses one can recognize support and resistance levels which can
also be used for further trading on the placement of stops.

The
various patterns of correction are seen to involve some relative
retracement of prices in a trend. Robert Rhea in his Dow Theory likened
these to and fro movements of prices to the movement of the tides. In
military terms it would be an advance of two, three, or whatever, steps
forward and one back before further advance: you prepare your defense
of this new position, assure your supplies and supply lines, you in
fact consolidate your position in readiness for the next advance.

The
amount of retracement tend to fall into predictable percentage amounts
in any given trend be it short or long term. These predictable amounts
tend to be Fibonacci fractions of the price distance covered in the
last move of the trend. Who or what is Fibonacci? Fibonacci was a
thirteenth century customs officer in Pisa. He was a mathematical
genius and introduced Arabic numerals to Europe. Of his three major
mathematical publications his masterpiece was Liber Abaci – the Book of
Calculations. In this opus he solved the conundrum of the mathematical
progression, the sequence of progression being the following : 1 + 1 =
2 ; 1 + 2 = 3 ; 2 + 3 = 5 ; 3 + 5 = 8 … etc.

The sequence has interesting relationships :

So
what? Well these ratios are the very ratios of the classical Greek
golden rule of art and are also the relationship of growth in nearly
all things in nature, e.g. the spiral structures of the inner ear to
the spiral of the Galaxies. The Elliott Wave Principle is founded on
these relationships of growth and retracement. The Fibonacci fraction
or ratios are 0.38 (38%), 0.5 (50%) and 0.62 (62%) in whole numbers of
the length of the trend. These are very close to the common perception
that stocks tend to correct by one third, one half or two thirds of
their recent trend.

When prices seem to be correcting a
significant move one can quickly calculate and identify these possible
Fibonacci points of retracement. If prices retrace to one of these
levels and find support then this could prove to be a good, low risk
area to enter the market or add to your previous stock holdings. If
correction exceeds the 62-66% it is then very probable that the
previous trend has failed and a reversal is truly in effect.

Speed Lines

The
late Edson Gould, another brilliant market technician, advanced a
further development of this relationship of retracement of trend.

This
gives insight not only to the degree of retracement but also the rate
of retracement, hence the term speed lines. The construction of speed
lines is easy. At the recent identifiable high of an up trend draw a
vertical line down to the level of the low of that trend. Then divide
the line into one third (or 38%), half (50%) and two thirds (or 62%),
then draw a line from the trend low through these points. These
represent lines of possible price support on retracement. For down
trends you simply reverse the technique. With computer analytical
software it is particularly easy to do this.

This insight into
prices and patterns is invaluable and can enhance the efficiency of
stock trading. More importantly perhaps, it can give one a well founded
sense of security on observance of price retracement so that one can
sleep at night and concentrate on working and playing hard by day.

Line studies help us
establish the concepts of supports and resistance on a more dynamic
basis and therefore we are able to follow the price movements as they
unfold either up or down. We can identify thereby, precise points for
entry and exit and also establish stoploss levels, which will help us
manage the trade from a risk and reward perspective. Line studies are
therefore an invaluable but extremely simple way of looking at markets.