Charts are the heart and soul of technical analysis. Many experienced traders wax poetically about how "charts talk to them" and make
bold statements about the future direction of a stock based on examination of price history. Yet to the untrained eye, these same graphs are but squiggles
across a page with no discernable order. Worse yet, how is one to make decisions as the media barrages you with stories about
dizzying rallies and gut-wretching selloffs, brokerage up/downgrades, and news items peppered with scandals or rumors? The financial industry wants the
public to believe investing is difficult, that the best choice is to turn your money over
to a professional manager who takes a hefty commission independently of whether they make or lose money in any given year.
Technical traders extract bits of information from charts which provide them with an edge. They follow the price action, looking for clues of accumulation or distribution of equities to guide their individual trades and find entry/exit points that minimize risk. Most often the idea is to follow institutions who trade in million share lots, and gain from the volatility that inevitably results from their large block trades. The price history alone is used as the basis for decision making, instead of research reports on industry fundamentals, earnings reports, or federal monetary policy.
The charts I have built for this site extract the most meaningful pieces of information from price fluctuations. The foundation is based upon time-proven principals of technical analysis, synthesized into a pattern recognition and swing trading system. The overall goal is to enhance my own trading style by utilizing a decision support system to find the best setups and minimize emotional aspects which could force a bad decision or rushed trade. Price labels, pattern setups, and trendlines are all drawn automatically by the C++ code, built upon elements of pattern analysis from Edwards and Magee, Fibonacci and Gann channel techniques from Robert Krausz, and trend-following filters to maximize profits. This essay details the approach the chart component uses to construct swing trade sequences - a background into the mechanics of price analysis and pattern evolution.
Support / Resistance
The basis for all charting begins with the notion of support and resistance. In the simplest terms, support is a price level at which a stock experiences buying
and downward motion is halted, whereas resistance is a level at which one would expect profit taking and selling pressure, halting upward momentum.
These prices can be determined by a number of factors, but most often
correspond to a price extreme - one which the trader remembers or visible when inspecting the price history.
In the chart below, this stock (NYSE:RIG, Transocean Inc, a member of the oil services sector) is currently experiencing movement in between two extremes - a signficant low around 18 in October 2003 and minor spike lows around 21 in August and February. The high at 25.89 is most interesting, since that level corresponds to a selling pressure point that was also found in the month of August. Without any further historical reference, a trader isn't left with any real action points, and would consider this stock in consolidation between 18 to 26.
What determines these price extremes in the first place? A spike high is any price point that has lower-highs on both sides of it.
Similarly, a spike low is a price point with higher-lows on both sides. Before the wide use of computers and sophisticated trading
software, professional traders would note these points on their charts by circling them with a marker. These points were referred
to as ring high and ring low. As more of rings
are added over time, a short-term market high with lower-highs to either side of it will inevitably appear. This price takes on more significance,
and it is labelled as an intermediate-term high - IH. Any short-term low with higher short-term lows on both sides of it is an
intermediate market low - IL. As you can imagine, after comparing intermediate-term spikes, you come up with long-term market highs and lows - LH, LL.
These are the true tops and bottoms.
|Market structure is the technical term use to describe these price fluctuations. A trade made at intermediate-term market highs and lows offer the greatest profit potential, since the most dynamic rallies and declines will start from these levels. Even as a short-term trader, positioning trades at these points provides you the chance to catch the biggest moves.|
Retest and Confirmations
Some of the most powerful pieces of trading information are revealed when a price spike is retested. This is a bold statement, since it implies that
tops and bottoms aren't ever really formed in isolation, but instead an attempt is made to revisit a previous price level. Market technicians make careful
observations of how traders behave around previous support and/or resistance levels. If we refer back to our previous example, after another two months pass,
prices drift lower and come within a few cents of falling beneath the previous spike low at 18.10. This is often the most emotional spot, since breaking to new lows
means that anyone who bought in the last 8 month period will be holding onto a losing position. For the technical trader, these points represent the most opportunity
and often look for a pickup in volume associated with this emotional response. If the price fails to break below a previous spike low, we can say that the support
level has been confirmed. The same principal applies to resistance if rising prices fail to penetrate above a previous spike high.
In the chart below, the gray volume bars and moving average have been turned on to gain further insight. Even though we are essentially at the same price level as the last chart, note the increase in volume as prices approached the previous lows. Another key piece of information is presented in the burgundy moving average line. The charting code will use that value (in this case, the f8 label in the title implies an 8 period sampling) as the primary condition for evaluating whether a spike low/high is valid. As prices cross above/below that threshold, a label is placed on the price extreme most recently found. Examining this relative to the October spike low, and associated volume increase, we say that support is confirmed around 18.
There is one more vital clue that is furnished when comparing two prices. It is the idea of a trend. An uptrend is defined as a state of rising prices, the essential ingredient is the presence of increasing spikes up (higher-highs, +hi) and shallow retraces (higher-lows, +lo). Similarly, a downtrend has lower peaks (lower-highs, -hi) and prices make new lows (lower-low, -lo). As any price is retested, the charting code will do comparisons relative to the last price extreme and furnish labels which indicate movement relative to the previous price spike. In the example above, the "+lo" indicates the first higher-low has been registered, if even by the slimmest of margins.
From geometry we learned that it takes 2 points to create
a line. A characteristic of a line is its slope, and the ability to calculate values at specific points along its path. The blue lines below represent such elements, drawn
through our price extremes. In charting these are defined as trendlines, since they capture the notion of rising or falling prices. They are particularly relevant
to the technical trader, as prices on any particular date can be compared against the prevailing trend.
The real magic begins in the presence of two spike highs and two spike lows. By comparing the slopes of the two trendlines formed by the price extremes, we determine a pattern which can fall into the general classification of trend, consolidation, or reversal. As we shall later see, there are different buy and sell signals that are generated as prices approach the trendline boundaries. Using our example, as prices retest the previous spike high at 26 and back off, a "+hi" higher-high is registered and the structure is called as a "[range hi]". The primary reason for considering this pattern to be a trading range is the near horizontal slope of the upper and lower trendlines.
In recent months, there is an advertisement for ChannelingStocks.com which entices the listener to trade like the pros. Identify stocks riding in a channel - "Buy low, sell high. Again and again." the speaker goes on to banter. This is exactly such a case identified in this situation, since prices remained locked within the bounds of the trendlines defining the upper and lower range. Note how many times prices test the lower line slope, yet fail to close below the line - along with a jump in volume as the nerves of traders are tickled each time the price dips to $18+change. As we later find out, these are institutions accumulating large blocks at the most advantageous price levels.
In a search for support and resistance levels, we revisit the idea of drawing circles around ring highs and lows. Each bar is examined, looking two bars on either side for prices which fail to exceed the range. If it meets this criteria, a dot is drawn at the spike extreme. Line segments are used to connect the dots, and a series of short-, intermediate-, and long-term swings emerge. Comparing this to the series of labels being highlighted by the charting software - we note that all of the short-term spikes are omitted. This is a deliberate attempt to focus on the most significant trade setups. From a market structure point of view, the current juncture is shaping up as an intermediate low, one which offers the greatest trading opportunity.
This final chart brings us up to the day on which this essay is being written - January 30, 2004. Here we witness the beginnings of a possible shift in momentum.
This pattern breakout is signalled by a close above the upper trendline, and denotes a change in character from the previous range-bound environment. The next confirmation step that we
will be watching for is based on the notion that "past support becomes future resistance" and "past resistance becomes future support".
In our chart example, we are looking for a confirmation of this second principal. More specificially, if price return back around $26, this should be met with buying (as compared with early selling to be expected at upper channel boundary.) The technical trader can start to evaluate targets based on the pattern setup. Whereas previously prices were expected to range from 18 to 26, if prices hold above 26 on any retest, the trend should eventually carry prices up to the $34 point by adding the height of the range to the breakout point. 26 breakout + 8 range = 34 target. Only time will tell if that level is achieved.
It is now three months later and prices haven't yet achieved the target measurement. Instead, the previous resistance encountered around 26 is now
acting as a support level on pullback. This is very typical in pattern evolution - double top/bottom trigger points are revisited,
necklines of head and shoulder evolve into resistance, whereas channel boundaries or cup and handle rim (very similar to our RIG example) become support on pullback.
Note that the filtering sensitivity has been changed to show the original trendline boundaries. An intermediate high is registered at 31.94. Smart traders will take the opportunity of a revisit to 26 to accumulate long positions before the next push higher.
On June 15, 2004 a buy signal is triggered as prices once again close above the 26 dollar level. The "up channel" pattern suggest that the market is no longer acting in a range-bound manner. The trend has changed to an uptrend with the confirmation of the first higher-high and higher-low sequence. Note the slopes of the newly defined channel; it is very common for the upper and lower bounds to be parallel to oneanother.
One of the most difficult decisions a trader encounters is when to exit a postion. At what level are losses cut, and just how far do you let your winners run? Handling losses is often based on the predetermined risk as the trade is setting up. In the case of profitable trades, it helps to determine a level / signal / catalyst which will trigger an exit. Originally a target of $34 was projected, yet instead of halting as prices reached the upper channel bounds, they paused briefly before continuing higher. Using the same principals for first target, we apply the idea that swings will move in equal-sized impulses. From the $18 low, prices moved to near $32 in a single motion, a gain of $14 (measurement). After a breakout above $30-32, a $14 measurement takes it to a $44-46 target.
RIG monthly chart as of the close today.  Note the first ring low at $18.10 from the chart above.
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