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Broad and Wall and burned with mudi shouting and rejoicing..

This same newspaper may have repeated this idea applied to program trading after the stock market plunge in October 1987. Nevertheless, charting has become part of the financial industry, whether the analjst is interested in the ftindamentals of supply and demand or pure price movement. The earliest authoritative works on chart analjsis are long out of print, but the essential material has been recounted in newer publications. If however, a copy should cross your path, read the original Dow Theory by Robert Rhea; most of all, read Richard W Schabackers outstanding work Stock Market Theory and Practice, which is probably the basis for most subsequent texts on the use of the stock markel for invest

EWScLBbacker,a»cklJ.«krtThet7an<3Practice(ForbeE,NewY lS»,pp 595-

4EobartD J-lmliigee,Tec.Uucal.Uialysis SockTreut (J-lmliigee, cfTiug 14B,i..ter It-i

5EicL.«.lD Wycbfi, .. lJ.«ketTecLuique, Number . New Y.dc. 1933, p 105. 6 Eobart I Lea, D. Thev .Vail-Ballon, Biughaiut.,,, 1 ,, 193 j.

ment or speculation. The most available book that is both comprehensive and well written is Technical Analjsis of Stock Trends by Robert D. Edwards and John Magee. it is confined entirely to chart analjsis with related management implications and a small section on commodities. For the reader who prefers concise information with few examples, the monograph by W.L. Jiler, Forecasting Commodity Prices with Vertical Line Cbarts, and a complementary piece. Volume and Open Interest, A Key to Commodity Price Forecasting, can still be found. A valuable recent addition is jack Schwagers, Sdnvager on Futures: Technical Analjsis (Wiley, 1996), the first of a three-volume set.

The Dow Theory

4n its basic form, the Dow theory is still the foundation of chart interpretation and applies equally to stocks, financial markets, commodities, and the wide variety of vehicles used to trade ttiem. Its major premise is that averages remove a large amount of extraneous price motion; therefore, Dows original work applied exclusively to averages and not to individual stocks. In fact, Dows Industtial, Utility, and Transportation averages have survived the test of time. The difficulty with interpreting stock movement is in the thinness of a specific issue especially in the early part of the twentieth centurj; its fixed number of shares and light volume made the movement of one stotk an unreliable indicator of an economic turn. Taken in total, it would be improbable to move the average by the manipulation of a single issue; hence, the averages become the subject of analjsis. Commodities, especially the financial and index markets, differ from stocks in their enormous volume, as demonsttated by the Eurodollars, which can trade exceptionally high volume with only the shghtest price movement. In ftitures, frading can be hmited to one primarj contract with htUe distortion because of constant massive arbitrage between ftitures and cash, and between one bank and another, especially in the interest rate and currency markets The possibihty of one trader influencing the U.S. bond market (other than the Chairman of the Federal Reserve) for more than a few seconds is remote to the point of no concem. When working in financial markets a single product is often given the same significance as a sector in the stock market when constructing a portfoho or index, yet in the footsteps of Dow, a group of international interest rates, with similar maturities, or a U.S. dollar index, can still be a valuable substitute for a single market.

The Dow theory defines price motion, as represented by the average, in three distinct primary, secondarj, and minor frends. These elements have often been compared with the tide, the wave, and the ripple. The primarj frend denotes the main move that exceeds lOo of the original price; the secondarj frend is an adjustment or correction, and the minor movements are day-to-day fluctuations. The theory emphasizes the main move. As Angas said: simple Take the grand view." it is easier to identifj the dominant frend than to worry about every change in direction.

Accumulation and dishibution are the beginning phases of a bull or bear market. Accumulation is the period in which the insiders begin to acquire a long position in anticipation of a bull move. In charting, this is traditionally seen as a wide formation at a low price with increasing open interest and erratic peaks in volume representing large purchases. The dishibution phase serves the same function for anticipated bear moves.

A unique part of the original Dow theory that prevents it from being apphed to commodities markets is the principle of confirmation, requiring that a signal be produced by more than one average. There has been some criticism with regard to the significance of an indushial group being confirmed by a rail, but the concept seems sound. If the pu ose of

at Neck ITV, 1974), and irald .Ifpel

The frendline remains the most popular and readily recognized tool of chart analjsis. It can be any of the following:

A support line is drawn to connect the bottom points of a price move. A horizontal support line is extremely common and represents a firm price level that has withheld maitet penetration. It may be ttie most significant of all chart lines.

A resistance line is drawn across the price peats of a sustained move, or a horizontal resistance line representing the fixed level that resists upward movement. Resistance lines are not normally as clear as support lines because they are associated with higher volatility, which causes erratic price movement.

A channel is the area between parallel support and resistance lines that serves to contain a sustained price move. When the support and resistance lines are relatively horizontal, or sidewajs, the channel is called a trading range.

A bullish support line would then be a rising line drawn across the lowest points of a price move, and a bearish resistance line is a declining line drawn across the highest peats of a price move.

Formations for Accumulation and Disfribution

Most of the effort in charting goes into the identification of tops and bottoms. Because many of these formations unfold over fairly long periods, they have been called accumulation at the bottom, where tjpical stock investors slowly buy into their position, and disfribution at the top, where the invested positions are sold off. The most popular of these formations are:

Head-and-shoulders bottom and top Common rounded upward or downward turn

Triangular bottom and top of an ascending, descending, or sj-mmefric shape, such as a friangle, flag, or pennant Ascending bottom and top "V"-bottom (a "V"-top is usually referred to as a spike) Double bottom and top

the Dow theory is to identifj major trends in the economy, it is unlikely that the average of one stock group would be going up and the other group moving down in a well-defined inflationary or deflationary period. In the same way, one would not expect the price of corn to increase and the price of wheat to decrease in absolute terms. A period of inflation should uniformly affect stocl and commodities; any items varying from the total pattem should be explained on an individual basis.

The relationship of the number of shares or contracts traded to the development of a price move is characterized by sajing that "volume expands with the trend." Whether a bull or bear maitet, activity increases as the trend becomes clear. In futures, the open interest has been treated in the same manner, with increased open interest, especially during the accumulation and distribution phases, a sign of a new move forming.

The Dow theory has other points that have been inco orated into chart inte retation. The exclusive use of closing prices is important for two reasons: (I) they are most closely followed by the tjpical speculator, and (2) they discount the effects of any positions taten by floor traders who are day-trading. Support and resistance lines were introduced as a substitute for the secondarj move, which may have been difficult to define Lastly, the theory expressed a trading philosophy by stating that a trend should be assumed to be intact until a reversal occurred.


Chart analjsis applies straight lines and geometric formations extensively. They can be classified into broader groups of trendlines and channels, accumulation and distribution, and other pattems. In addition, chart formations can apply to major or minor price changes and to different time frames.

Complex bottom and top, including a triple bottom or top, or a combination of other formations Broadening bottom and top

Most of these pattems are self-explanatory and are covered in detail in many books devoted entirely to the topic. In addition to the classic by Edwards and Magee and the monograph by Jiler, the reader can find considerable value in John Mu hys-BarCTiarting" in Kaufinan, Handbook of Futures Markets, and more recenUy Scbwager on Futures.. Technical Analjsis. Instead of giving examples of these formations, we win look at them in the context of trading rules

Individual Pattems

In addition to the broader pattems noted above, there are specific situations of short duration that have been noted by the chartist including:

Gaps Spikes

Reversal days Thrust dajs Cups and caps

These will be covered in the foUowing sections.

Major and Minor Formations

Throughout the study of charting, it is important to remember that the same pattems wiU appear in short- as weU as long-term charts. An upward trendline can be drawn across the bottom of a price move that only began last week, it can represent a sustained 3-year trend in the financial markets, or a 6-month move in coffee. In general, the longer the time interval, the more significant the formation. Contract highs and lows, weU-defined trading ranges, trendlines using weekly charts, and head-anddioulder formations are carefiiUy watched by traders. Obscure patterns and new formations are not of interest to most chartists, and without the support of the traders, conclusions drawn from those formations have no substance. The basic charting course also includes interpretation of volume and open interest and a variety of rules for using the formations.


The simplest formations to recognize are the most commonly used and most important: horizontal support and resistance hues, buUish and bearish support and resistance hues, and channels. Proper use of these basic hues is essential for identifjing the overall direc

id J..b. IJurfliy, "Bar n.artiug" in 9 jack D ScLwager, Scbwager on Futures TecLuical .lualysis . J. .liu Wiley & Sons, New Y. mf-.

tion of the market and how it gets there. An understanding of these pattems wiU be helpful to computer-oriented analjsts, many of whose techniques have been modeled after chart formation. More complex formations are likely to enhance good performance but cannot compensate for poor frend identification.

Once ttie support and resistance hues have been drawn, a price penetration of those tines creates the basic ttend signal (Figure 9-Ia). The buUish support tine defines the upward ttend, and the bearish resistance tine denotes the downward one. For long-term charts and major ttends this is often sufficient but frequent small penetrations of both long- and shortterm frendlines can be avoided by placing a band around both tines (Figure 9-lb). A short signal occurs

when both the frendline and the band have been penetrated. Because of the basic charting rule-----Once broken, a

resistance level becomes a support level and a support level becomes a resistance Ievel"-the original frendline (or a frendline plus and minus a band) can be used as a stop-loss. If prices penetrate the stop-loss point ttien return to the original formation., there has been a false breakout and the original ttendlines are stiU valid.

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