The trend is your friend
Technical analysts dispute many finer points of their
craft but are agreed on the premise that the share
price moves in trends. The usual advice to investors
is to go with the flow. An uptrend in the share price
shows that demand is greater than supply, and you
should buy the shares for as long as it lasts. Conversely,
if the trend is down, you should sell the shares or
go short on them, again until the trend reverses.
The longer a trend lasts, the more reliable it is
likely to be, technical analysts are agreed. Trends
remain in force until they are broken, when a charting
software package may be programmed to trigger an alarm.
A trend may be in many time frames simultaneously
and the short-term trend is more likely to continue
if it is moving in the direction of the longer-term
one, technical analysts say.
Victor Niederhoffer, a US trader and author, has challenged
whether the trend exists. In so doing, he has attacked
the concept of technical analysis at root.
Support and resistance
The resistance level is the high point on a chart
where the stock price has stopped rising, because
investors will not buy further and sellers have emerged.
At the other extreme, the support level is where investors
have stopped selling.
The more a support or resistance line is tested, the
more effective it is considered. Support and resistance
often arise at round numbers which, in the case of
stocks, are often 90p, 100p or 200p.
Trader David Jones explains to packed seminars in
London how he uses support and resistance to help
time his own trades. ‘If a share price rises
above the resistance line, you buy, and if it goes
below the support line, you sell.
The boundaries are self-renewing and, once the share
price has fallen below the support level, it becomes
the new resistance line. It makes sense because some
of the shareholders who failed to sell before the
share price fell below the old support line will seize
the opportunity if the price should subsequently return
there. It works both ways and the resistance level
after the share price has risen above it becomes the
new support level.
Trend channels
Once a trend has three tops or bottoms in succession,
a trend line may be drawn against them, and it confirms
the trend. A trend channel is the space between a
trend line touching the highest points, indicating
resistance, and a parallel line touching the lowest
points, indicating support.
In the case of a volatile stock, the trend channel
will be large enough to trade profitably on price
fluctuations within it. It brings a whole new meaning
to the term cross-channel shopping. Some traders divide
the trend channel along the middle with a horizontal
line and, when the share price is above it, they sell
the shares, and when it is below, they buy them.
Chart patterns
Many are sceptical about reading meanings into patterns
in the charts. The pattern is the most famous manifestation
of technical analysis. It appears on any type of chart
but is clearest on the line chart. Any pattern is
constructed from the price fluctuation on the chart
representing the struggle between buyers and sellers.
The pattern repeats itself in different markets and
on different stocks.
Every pattern shows how the dynamics of supply and
demand play out, and technicians believe that it has
some predictability. Some use the patterns to time
trades and predict future price movements, and others
are cynical, even sometimes from within the ranks
of technicians.
When one side gets the upper hand, the line breaks
out of the pattern. On an upside movement, trading
volume tends to rise. As a rule of thumb, the move
is confirmed only when it has exceeded 3 per cent
of the share price, and there are many false breakouts.
If a breakout happens, there is a neat, if not wholly
reliable, rule on how long it should last. Measure
the full depth of the preceding pattern and project
it as a minimum from the point of breakout. This is
your target length. Make allowances for a likely temporary
retracement, which may revert to the original pattern.
There are continuation and reversal patterns. Continuation
is when the share price continues in the same direction
as before the pattern started, confirming the trend.
Reversal is when a trend is changing. Unfortunately,
patterns do not always work out as planned and it
is not always clear whether they represent continuation
or reversal.
In the examples below, I have put some key patterns
in the more appropriate of the two categories, making
it clear where they may have a foot in either camp.
Candlestick patterns are beyond the scope of this
short book, but you will find plenty of these in my
book How to Win as a Stock Market Speculator, also
published by Kogan Page.
Continuation patterns
Here are some common forms.
Flag
The flag forms in a strong trend, whether up or down,
typically in less than three weeks, and technicians
consider it a reliable continuation pattern. It takes
the shape of a flag-like consolidation in the share
price with a small price range, formed on declining
volume, which is followed by a significant move. The
pattern on the chart looks like a flag and its flagpole.
In an uptrend, the flag will slope downwards and,
in a downtrend, upwards.
Gap
The gap takes the form of a physical break in share
price movement and is often, but not always, a continuation
pattern. The less frequently the gap arises, the more
significant it is, particularly on a heavily traded
stock. If trading volume rises with the gap, it also
strengthens the message.
Technicians have identified four types of gap: common,
breakaway, runaway and exhaustion.
They will usually ignore the common gap, which arises
when trading is congested within a range due to lack
of interest, a frequent situation with less liquid
stocks.
The breakaway gap arises when the price breaks out
of a range following a price reversal, and it suggests
a new trend.
The runaway gap is rarer and signals that the trend
will be continued. It is also known as the continuation
or measuring gap.
The exhaustion gap arises when a fast move in the
share price has almost reached an end. It indicates
that the trend is weakening and may be a continuation
or a reversal pattern.
Pennant
The pennant consists of some straight lines drawn
through highs and others through lows that converge
to complete a small symmetrical triangle (see under
Triangle below). The pattern is formed on declining
volume after the share price has moved up or down
quickly, and usually within three weeks.
Rectangle
The rectangle is shaped as it sounds. It is a pricing
range where the price swings up to a resistance line,
then down to a support line until breakout. There
is no rule on how many times price movements must
touch the upper boundary.
The rectangle is most often a continuation pattern.
This type of rectangle forms quickly, has a small
price range, and is seen as more significant if it
is nestling within a larger one. The rectangle can
be a reversal pattern, in which case it forms more
slowly and with a broader price range.
Triangle
The triangle consists of two lines that converge at
an apex. One line represents resistance and the other
support. The more often the share price touches these
lines, the more reliable the pattern.
The most reliable breakouts from a triangle are believed
to arise between 50 and 75 per cent towards the apex.
Much earlier, the breakout is often false, meaning
that the pattern is likely to continue. A symmetrical
triangle has a top line that slants down and a bottom
line that slants up. It may arise in an uptrend or
a downtrend. If the price breaks out in the same direction
as the previous trend, as is most usual, it is likely
to be a continuation. If it breaks out in the opposite
direction, it is likely to be a reversal.
The ascending triangle has equal highs but higher
lows. In an uptrend, it is often a continuation pattern,
and, in a downtrend, it is often a reversal. The descending
triangle follows the same principle in reverse.
Wedge
The wedge has boundary lines that slope up or down
together into an apex. If it is slanted against the
trend, it indicates likely continuation. If it follows
the trend, it suggests reversal. The pattern is usually
completed within three months.
Reversal patterns
Here are some common forms.
Broadening formation
The broadening formation, known as the megaphone,
is a rare bearish pattern. It arises when at least
three successive peaks have each risen, accompanied
by rising volume, and at least two successive troughs
have fallen, accompanied by contracting volume.
The tops should be joined in one line and the bottoms
in another. The two lines diverge.
Double top or bottom
The double top is a similarly rare bearish pattern
and it develops usually over some months. The share
price rises, falls back, then returns to its old peak,
or close to it, and reverts.
The double bottom is the same in reverse, and is a
bullish pattern. Some technicians consider it reliable
only if trading volume rises as the second bottom
is formed.
Head and shoulders
The head and shoulders is the best-known reversal
pattern and is a bearish signal. The share price moves
up and reverts to form the first shoulder, which is
a peak in the trend. A sharp reaction will follow,
and the share price dips to form a trough. It will
then rise to a higher peak, which becomes the head,
and will drop back again to form a second trough.
The share price will rise once more, but can only
form another shoulder before falling down and breaking
the support level, which is known as the neckline.
The reverse head and shoulders is a bullish reversal
signal anticipating the end of a bear market.
Saucer top or bottom
The saucer top is a rounded version of the head and
shoulders or double top. It is a bearish signal that
occurs in tired bull markets. It shows the share price
rise, turn slowly and reverse into decline, tracing
a circular motion on the chart.
