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be misleading and are ot but little value except when "lines" are being tormed. the day to day movement must be recorded and studied, however, because a series of charted daily movements always eventually develops into a pattem easily recognized as having a forecasting value.

Sometimes, tops and bottoms are reached, and the trend changes without lines being formed. In addition, lines sometimes form in the middle of a confirmed primary trend. This can happen for one of two reasons: either the market has been driven up (or down) rapidly and many traders and speculators take profits, thus temporarily halting the movement of prices; or the market is uncertain of the future and the mixture of opinion holds prices at a relatively constant level. In the first case, I call this process consolidation. In the second case, I call it a waiting market.

December Swiss Franc Futures Daily Bar Chart

8000 -




. Frice Breakout -

il ll".

I, i1.4"




TO 20/20 © 1991 CQG Inc. Figure 5.7 December Swiss Franc Futures-a price breakout, usually a good buy signal.


For trending markets, the volume relationship is very important. As Rhea put it:

The Relation of Volume to Price Movements:-A market which has been overbought becomes dull on rallies and develops activity on declines: conversely, when a market is oversold, the tendency is to become dull on declines and active on rallies. Bull markets terminate in a period of excessive activity and begin with comparatively light transactions.

An "overbought" market is, by definition, one in which prices have been driven up by feelings, hopes, and expectations based on factors other than sound business judgement and value considerations. It occurs at a point after people with superior information have largely left the market, and general participants are beginning to abandon their former enthusiasm. The market is ripe for a minipanic

wherein the slightest sign of a downward move in prices is enough to start a flurry of selling, putting downward pressure on prices. This is why you see relatively high volume on declines and low volume on advances in an overbought market.

Converse reasoning applies to an oversold market. It occurs after a point where shrewd investors have begun to buy securities whose prices have been driven down in a prior sell-off. A resurgence of hopes and expectations builds in the market which, with slight provocation, will build into a mini-boom in prices on high volume. Although volume relationships apply in any financial market, the stock market is unfortunately the only one where volume figures are immediately available. In the commodities markets, estimated volume figures are released on the following trading day and the actual numbers two days later. It is important to remember that volume relationships usually, but not always, apply. They should only be used as subsidiary, not primary, considerations.


Now you know what a trend is, what lines are, and some of the key factors which cause or indicate that a trend is changing. Youve seen the importance of volume relationships and how they reflect the psychological status of the market. If you leam to think about market behavior in the terms described in this and the last chapter, you will already be a major step ahead of the crowd.

The next step is to reduce this knowledge, especially knowledge of a trend and the change of trend, into a simple and manageable system. What Im going to present is a charting sy stem that is tmly unique and remarkably simple. The system is based on pattem recognition, which is, by definition, a technical method. But before I show it to you, I need to describe both the benefits and the dangers of any technical method.

Wall Street is full of market technicians. Floor traders, upstairs traders, speculators, and even some long-term investors take advantage of the potential to anticipate market movements by identifying pattems that tend to recur over time. There is no mystery in the reason that these pattems develop. All things being equal, people tend, from a psychological standpoint, to respond to a similar set of conditions in a consistent way. But human psychology is enormously complex, and no two sets of market conditions are ever identical; so technical analysis must be applied cautiously to be used successfully in forecasting market behavior.

According to Robert Edwards and John Magee, "Technical Analysis is the science of recording, usually in graphic form, the actual history of trading (price changes, volume of transactions, and so on) in a certain stock or in "the averages and then deducing from that pictured history the probable future trend." Their basic premise is very similar to that of Dow Theory -that all of the knowledge available in the marketplace is already factored into prices. But unlike Dow Theory, market technicians think prices and pattems of prices are the only considerations that matter.

I am not a pure technical analyst, but I have made too much money from technical observations to dismiss technical analysis as some "fundamentalists" do. It is an important auxiliary tool which is largely unrecognized by many market players, especially long-term investors, to help make market decisions in which all the odds are in your favor. But standing alone, as the primary means of evaluating investment or speculative altematives, technical analysis can not only be ineffective but misleading.

A simple survey of professional traders, speculators, and investors would bear out the degree of efficacy of technical analysis. Those who rely totally on charting methods seldom have consistent records. For example, in 1974,1 was approached by a technical analyst named Leo who told me that he thought I would profit from h is knowledge. I hired him on a trial basis for $125 a week and planned to pay him a percentage on his recommendations that paid out well. Anyway, Leo was

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in the office at 6:30 A.M. every day, doing over 120 charts in living color, using methods I still dont understand. He worked 16-hour days, and he obviously knew a lot about the markets, maybe too much for his own good.

When I asked him for recommendations, he would show me the charts and say things like, "This stock might be forming a bottom," or, "This stock looks like it may fill in the gap." But whatever he said, it was always indefinite and always offset by a confusing array of other possibilities. I would ask, "Okay, but what should I do, buy or sell?" Leo just couldnt give me a simple, straight answer. And what I remember most about him is that the ends of his shirt sleeves were frayed, and that he ate homemade tuna sandwiches for lunch.

Im not saying that this is the case for all technical analysts, but the point i s that technical analysis, as such, does not lend itself to thinking in essentials. If you watch FNN (The Financial News Network), and you should, youll see what Im talking about. Different technical analysts interpret pattems differently, and they all have their own story. In my view, the best thing to do is identify just a few essential technical principles and use them as auxiliary tools. Those who encompass these kinds of technical methods into a broader system which includes rigorous and sound analy sis of economic fundamentals and detailed evaluation of specific securities and commodities do quite well by them.

For purposes of this discussion, it is important to understand the activities of three major groups of technicians: tide watchers, manipulato rs, and purists.


The Merits and Hazards of Technical Analysis

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