StockCharts Blogs - ChartWatchers

TECHNICAL ANALYSIS 101 - PART 11

This is the next part of a series of articles about Technical Analysis from a new course we're developing. If you are new to charting, these articles will give you the "big picture" behind the charts on our site. if you are an "old hand", these articles will help ensure you haven't "strayed too far" from the basics. Enjoy! 

(Click here to see the beginning of this series.)

Price Patterns

Price Patterns result when the market is not in agreement on the value of a stock.  Essentially, they are the “visual remains” of a big battle between Bulls and Bears.  In many ways, they are like weather patterns that you see on the nightly news.  Often today’s weather can be forecast by looking at yesterday’s atmospheric data but occasionally (frequently?) the forecast is wrong.  Similarly, chart patterns often but not always indicate future price movements.

At their core, most price patterns are combinations of several trendlines.  The simplest pattern is the Rectangle Pattern.

In a rectangle pattern, price moves between two horizontal lines of support and resistance.  In order to qualify as a rectangle pattern, both support and resistance lines must be touched at least twice.  Rectangle patterns have a narrow or wide price range and last from days to months.  The pattern ends once the line of support or resistance is broken. 

A price break through resistance may be anticipated if volume expands when prices rise and contracts when prices fall within the rectangle pattern.  An imminent price break above resistance may exist if prices don’t fall to the support line before rising again.

A price break through support may be anticipated if volume expands when prices fall and contracts when prices rise within the rectangle pattern.  An imminent price break below support may exist if prices don’t rise to the resistance line before falling again.

As illustrated above, as soon as the pattern breaks down, the top (or bottom) of the rectangle changes into a support (or resistance) line for the stock.

Rectangle patterns clearly show the battle between bulls and bears with the bulls repeatedly buying when prices hit the support level and bears repeatedly selling when prices hit the resistance level.  At some point, one of those groups will “win” and prices will breakout of the pattern.  The longer prices have been in the pattern then the larger the “breakout move” will be and the more significant the new support/resistance line becomes.

Another common price pattern is the Triangle Pattern.   The triangle pattern is very similar to the rectangle, except that the upper and/or lower trendlines that define the pattern are sloped instead of horizontal.

Go back to the rectangle diagram above and imagine that bearish sentiment about the stock was growing over time.  What would that look like?   Well, in that case, more and more sellers would not wait for prices to return to the level of the red resistance line before selling.  Instead, they would sell sooner.  That would cause the red resistance line to become a downward trendline forming a Descending Triangle Pattern.

Alternately, what if buyers started getting impatient and started buying before the stock got back to its green support line?  Then a Rising Triangle Pattern would form.

And what if both the bulls became more bullish while at the same time, the bears became more bearish?  Then both the red and green lines would be slanted and we’d have a Symmetric Triangle Pattern.

By the way, triangle patterns are also referred to as “coils.”  Can you see why?  As the upper and lower parts of the triangle get closer together, the battle between the bulls and the bears gets more intense and the suspense builds.  Obviously, at some point, prices are going to move outside of the triangle’s boundaries – but will they move higher or lower?  Psychological energy coils up like a spring inside of the triangle and the closer the lines get, the bigger the inevitable breakout will be.

As you probably guessed, the diagrams above are not realistic.  Typically, triangle patterns have a breakout well before the apex of the triangle is reached.  It is the direction of the breakout that is the key question when watching a triangle form. Will the bulls win?  Will the bears win?

A couple of clues can be found in the price action that precedes the triangle.  If the stock was in an uptrend prior to the triangle, there is a good chance it will break out of the triangle pattern on the upside and continue the uptrend.  In addition, rising triangles tend to breakout to the upside while descending triangles often break lower.  Symmetric triangles are usually not completely “even” – i.e., the support side may be stronger than the resistance side making the triangle “point up” or, if the support side is weaker, “point down.”  In that case, the triangle often breaks in the direction it is “pointing.”

Next time, we'll look at how to confirm these patterns with volume and examine some real-world examples.

ON HIATUS THIS WEEK

John will return for our next issue....

"IF THEY A YELL'IN; THEN YOU SHOULD BE SELL'IN"

The July-August stock market rally has caught many surprised given its strength and duration; however, we are of the opinion that this "freight train" is running of out of fuel, and shall falter from roughly current levels in what may be quite a "quick and nasty" setback at a minimum. It very well may take on a more decidedly bear market decline, but it is far too early for us to determine this.

Quite simply, if we look at the broad-based Wilshire 500 Index, we find the rally off the March low is substantial, but only insofar as a mean reversion exercise towards the 70-week moving average currently at 10,492. Looking back in time, we find that on a closing basis, the Wilshire tends to confirm bull markets once it breaks out above this moving average, and bear markets when this major resistance level proves itself with lower prices. We have just such a fulrcum point roughly 1.5% above current levels.

Our thoughts are simple: we expet thje 70-week moving average to provide resistance to this rally; and for prices to correct rather sharply. However, it shall be the character of that decline that will speak volumes - we hope of course - as to whether a major test of the March lows is in store. From a fundamental perspective - we believe that to be the case; but we have no solid technical evidence to support our supposition. Therefore, we are willing short sellers at current to slightly higher prices, and our stop loss will be two weekly closes above this moving average as we would want to give this position wide lattitude to work given the potential for a major inflection point and the volatiltiy that surrounds them.

In other words: "if they a yell'in; then you should be sell'in"; and traders do seem to be doin so.

LONG-TERM BUY SIGNAL

On Tuesday of this week our long-term model for the S&P 500 switched from a sell to a buy signal. While it is a simple model -- the signals are generated by the 50-EMA crossing over the 200-EMA -- it can also be very effective, capturing a gain of 28.7% over a period of 580 calendar days. During that period the S&P 500 lost -28.5%. Past performance is no guarantee of future results. In fact, like any trend following model it is subject to whipsaw, and will be unprofitable in some cases. It probably will not be fast enough to sidestep to sidestep a surprise crash, such as we had in 1987.

In fact, my recommendation regarding this signal is to use it as an information flag rather than an action flag. For example, we use the long-term signals to determine whether or not the market is in a bull phase or a bear phase. As of Tuesday we consider that we are in a bull market, and this is the long-term context within which we will interpret medium-term price action and technical indicators. Bull market rules apply. The market will tend to stay overbought, and, while overbought conditions require increased caution, they are not necessarily selling opportunities in a bull market.

Prices are still pressing the top of an ascending wedge formation. A pullback is possible, but I think, if it happens, it will be quick.

While price action and indicators continue to confirm our bull market assumptions, one indicator that is not confirming is 52-Week New Highs -- they are hardly expanding at all. I was concerned about this until I looked a little deeper into the matter. On the chart below I have drawn a brown rectangle to encompass the 52-week period in 2002-2003 preceeding and including the expansion of new highs that accompanied the initial breakout of the bull market. Note that the vertical price range inside the rectangle is about 250 points.

Now look at the price range inside the purple rectangle, which encompasses the current 52-week period for measuring new highs. It ranges from 1300 to 680, almost three times the range of the 2002-2003 bottom. The point being that the current 52-week price range is simply too wide by historical standards for an expansion of new highs to take place.

Now look at the price range encompassed by the orange rectangle, which is where the range will be in a few months. The top of the 52-week range will be dropping like a rock, making the expansion of new highs virtually guaranteed, providing a serious price decline does not occur.

Conclusion: The failure of new highs to expand in spite of a spectacular price move up, has everything to do with an unusually wide 52-week price range, and nothing to do with the internal quality of the rally.

 

Another tool we use to analyze the new high/new low indicator is the Relative to 52-Week High/Low indicator (s-to-52). Decision Point tracks each stock in a given market index and determines the location of its current price in relation to the 52-week high and 52-week low. We express this relationship using a scale of zero (at the 52-week low) to 100 (at the 52-week high). A stock in the middle of its 52-week range would get a "Rel-to-52" value of 50. The Rel-to-52 charts show the average Rel-to-52 for all the stocks in the market index shown.

The current Rel-to-52 reading is 56, which means that on average S&P 500 stocks have traversed a little more than half their 52-week price ranges since the March lows. As the top of the range compresses over the next few months, this index should move to the top of its range. More important to note is how this measure of internals demonstrates how robust the rally has been.

Bottom Line: A new long-term buy signal was generated this week, which means that we are technically in a bull market, and that bull market rules apply. The failure of new highs to confirm the rally is a mechanical issue, not a demonstration of internal weakness.

CAUTION IS ADVISED NEAR-TERM

Two weeks ago, I pointed out what appeared to be the early stages of a new trend of outperformance by the financials and suggested they might be primed for a move higher to rescue the stumbling stock market.  Right on cue, money rotated back into financials and we saw the Dow Jones US Financial Index rally nearly 10% in one week, breaking out above its May highs.  That spurred the S&P 500 to its highest level since mid-October 2008.  Therein lies the problem.  We've now retraced much of the collapse from late September and staying aggressively long at key resistance is not a good reward to risk proposition in my opinion.  The S&P 500 may ultimately break out and move higher, but let's deal with that when and if it happens.  For now, check out the resistance on the S&P 500 chart below:

 In addition to the price resistance, I've also plotted the 5 day moving average of the equity only put call ratio at significant short-term tops and bottoms in the S&P 500.  Any time this average drops below .60, a red flag is raised in my view.  It doesn't mean the S&P 500 will top as complacent readings have erred in the past.  However, it does make me aware of a possible short-term trend reversal.  Given the critical price resistance that the S&P 500 is battling right now, the significant number of net in-the-money calls that exist just one week before options expiration, and the rather complacent equity only put call readings of late (just hit .56, a 2009 low), we removed all exposure on the long side on Thursday and actually began shorting using a juiced ETF.  I feel the timing is right because we're at critical price resistance.  If the S&P 500 breaks out, it's a quick minor loss and we'll be back to cash looking for other opportunities.

Every month at Invested Central, we host a "max pain" chat the Sunday night before options expire.  This Sunday is no different.  Because there are so many stocks currently trading above their "max pain" levels, we'd like to invite anyone interested to join us as we discuss the theory behind "max pain" and its usefulness in trading during this one week free-for-all.  If you'd like to join us Sunday night, simply click here.

Happy trading!

Keeping an Eye on Bullish Percent

The Bullish Percent Indices measure the percentage of stocks on a Point&Figure buy signal for a given index. In general, an index has a bullish bias when its Bullish Percent is above 50% and a bearish bias when below 50%. Stockcharts.com users can easily keep an eye on the bullish percent indices in the Market Summary page. In fact, the table below comes directly from the bottom of the Market Summary page. The major indices are at the top, followed by the sectors.

As you can see, the Bullish Percents are above 70% for all the major indices. No sign of weakness here. Of the ten sectors, six have Bullish Percents greater than 79%. This is a sign of broad strength. Of the remaining four sectors, two are in the low 70s, energy is around 59% and telecom is around 55%. Using bullish percent to measure relative strength, energy and telecom are the least strong sectors right now. Of the major indices, the Nasdaq 100 and S&P 100 are the strongest (large-cap and large-cap technology). The bulls are in good shape as long as the majority of these Bullish Percents holds above 50%. You can read more on Bullish Percent in the Chart School.

TRENDING UP, DOWN OR SIDEWAYS?

Hello Fellow ChartWatchers,

Here's an article that first appeared in 2006 about using the ADX indicator.  With lots of stocks starting to trend upwards now, I thought it was a good time to revisit this topic.  Enjoy!  - Chip

Trend analysis is one of the most important technical analysis skills anyone can have. Knowing if a stock is trending or oscillating can have a big impact on what kind of approach you take to trading it. Stocks that are in a strong uptrend should be bought and held until one or more momentum oscillators show signs of weakness (a moving average cross-over for example). Stocks that are oscillating sideways within a trading range should be studied using oscillating indicators like Stochastics for entry and exit points.

So, how do you tell if a stock is trending or oscillating? And how do you tell if the trend is strong or weak? One way is to use the old Mark 1 Eyeball- but unfortunately that isn't always as accurate and impartial as one might like. A more objective technique is to use the ADX indicator.

The ADX indicator was invented by Welles Wilder, the same guy who created the RSI. It is part of an indicator "system" whoses official name is "Wilder's DMI". Wilder's DMI consists of three lines - the green +DI line, the red -DI line and the thick black ADX line. Check out this example that uses the Dow Industrials:

(Click the chart to see a live version.)

I've added vertical blue lines whereever the green +DI line crossed the red -DI line in a significant way (I ignored some whipsaw-like crossovers for clarity). When +DI is above -DI, the chart is in an uptrend. When -DI is on top, the chart is in a downtrend. The "strength" of the trend (up or down), is indicated by the ADX line.

Working through the chart from left to right, at first the Dow was in an "uptrend" (+DI is above -DI) and it was a "strong uptrend" because the ADX line rose to a relatively high level. Next, in early April, came a short period of oscillation that saw the ADX fall. After that, in late April, another uptrend developed but a couple of down days near the beginning of May prevented the ADX from indicating that the uptrend was particularly "strong".

After setting a high in the middle of May, the Dow entered a strong downtrend for a couple of weeks. Notice that the ADX line continued moving higher during this downtrend - don't let that confuse you! The level of the ADX indicates the strength of the trend, not the direction. In this case, this downtrend is the strongest trend on the chart and therefore has the highest ADX levels.

The right side of the chart shows that we are currently in another uptrend however the "strength" of that uptrend is very questionable. Notice how the ADX line was at a very low level in mid-August and has only begun to move higher recently. The ADX is telling alert ChartWatchers to pay close attention for signs the Dow's current uptrend is running out of momentum and react accordingly.

The calculation of the ADX is complex and beyond the scope of this article however, we have recently gotten a very detailed new book about the ADX into our bookstore that can tell you everything (and I mean everything) you ever wanted to know about this important indicator. Although it is pricey, serious ChartWatchers will find that "ADXcellence" by Dr. Charles Schaap is well worth the cost.

ITB VERSUS XHB

On Monday, I wrote a bullish message on the homebuilding group and suggested using the SPDR S&P Homebuilding ETF (XHB) as one way to participate in the housing recovery. I pointed out, however, that the XHB has a relatively heavy weighting in a lot of housing-related stocks that aren't necessarily homebuilders (like Home Depot, Bed Bath & Beyond, Masco, etc.). A purer homebuilding play can be found in another ETF -- iShares Dow Jones U.S. Home Construction (ITB) -- which is shown in Chart 2. The two charts are basically similar, show the same bottoming characteristics since last November, and are both on the verge of breaking out to the highest levels in nine months. On percentage grounds, however, the ITB has an edge. Since the start of 2009, the ITB has gained 23% versus 19% for the XHB (the S&P 500 has gained 9%). Since the March bottom, the ITB has rallied 87% versus 74% for the XHB (and 44% for the S&P 500). The top holdings in the ITB are homebuilders like NVR, DR Horton, PHM, Toll Brothers, Lennar, and Centex. The XHB offers participation in a broader array of housing-related stocks. If you want a purer homebuilding play, however, ITB would be the better choice.

COMMODITY SECTOR PICKING UP

On Thursday and Friday of last week, we saw the US dollar resume its downtrend, and the commodity sector begin to pick up participation as a result. This is likely to continue into the future as the US dollar is destined for lower lows; thus we are quite interested in finding parts of the commodity sector that have been "laggards" recently. The first that comes to the "radar screen" is the Agriculture group as it has been "most laggard." This group is primarily comprised of the grains such as Soybeans, Corn and Wheat; but the ETF that we are interested in - the DB Agricultural ETF (DBA) - is comprised of roughly 70% grains and 30% Sugar. This is fine for our puproses; and if we have to make a bullish fundamental case for DBA...it is that the bountiful harvest is already discounted, with any type of stress into harvest leading to a bit of short covering and perhaps a good deal of real buying if anticipated economic growth materializes.

From a technical perspective, we'll simply note that there are a series of higher lows and higher highs forming, which may or may not be part and parcel of a rising bearish flag pattern. But in any case, even if it were a bearish pattern - there is certainly room for an upside trade from its current $25 level to $30 in the weesk and months ahead. Quite simply, DBA is oversold per the 40-day stochastic, which increases the probability of a rather sharp move higher. Too, prices are breaking out above the 150-day moving average, which has been a rather bullish sign in the past as well.

If one chooses to consider this trade, then the risk is for a break of the recent lows at trendline support; while the reward is a trade to $30. Put another way; we'll risk $1.50 for a gain of $4.50.

Good luck and good trading,
Richard

FINANCIALS TO THE RESCUE?

During the initial phase of the market recovery, from the March lows to the early May highs, financials were a primary driver of the move.  Since that time, financials have lagged badly as sector rotation has caused money to flee to other, better-performing sectors over the last 8 weeks or so.  However, the relative outperformance that financials enjoyed in the Spring has returned of late.  Will it continue?  That's hard to say, but our first major clue is upon us.  Check out the following chart:

Should the sector break above key near-term price resistance, it would be prudent to look for companies within the sector primed to participate.  One such stock could be E*Trade Financial (ETFC) - for two reasons.  First, let's look at the one year chart:

More interesting, however, was the trading in the last 15 minutes on Friday as volume exploded on ETFC.  Check this out:

Over the last 90 days, ETFC has produced average daily volume of 47 million shares.  In the last 15 minutes of trading on Friday, ETFC traded 38 million shares.  Will there be news to account for such heavy volume?  It's impossible to say, but if technicals precede fundamentals......

Given the possible breakout on financials, I scanned the financial universe, searching for potential short-term trade candidates within that sector, to benefit from any additional strength in the group.  For the more aggressive active trader, I also used scans searching for small dollar stocks in the $1-$5 range that are showing increasing volume trends and other positive technical signs.  To access these trade candidates, complete with my technical commentary, click here.

Happy trading!

HOPING FOR A PULLBACK

Since the price lows of early-July, the market has moved relentlessly higher, penetrating the important resistance posed by the 200-EMA. When this rally began, a narrow window of fairly low-risk opportunity was presented. Those who missed it are now hoping that prices will pull back far enough to provide another good entry point.

The most obvious and promising pullback target would be a move down to the 200-EMA, but would such a move fuel confidence, or would it only serve to crank up the level of anxiety? As you can see, another ascending wedge has formed, and, if you have been following our commentary for a while, you know that an ascending wedge is a bearish formation with a high probability of a breakdown. If we do get a pullback, the next obvious fear will be that the pullback will not end, and that prices will break down from the wedge and continue on down to test the July lows.

 

Adding to the evidence supporting a possible breakdown are medium-term indicators, like those below, showing that the market is quite overbought, a condition that will need to be cleared. In bull market conditions, which I would ascribe to our current situation, it is possible for overbought conditions to be worked off even as prices move higher. That is to say that prices may not pull back at all, but simply break up and out of the wedge. To the other extreme, a healthy price decline can do the trick.

Bottom Line: For those who acted on our March 17 buy signal, contemplating the outcome of the ascending wedge and/or the possible pullback does not create much, if any, stress. But for those who are still out of the market and looking for a chance to participate in another up leg that has the potential to move prices up another 20%, the next few weeks will probably not be much fun.

One of these days, the market mood is going to switch back to bearish for an extended period, but, based upon price action to date, I must assume that the current setup will resolve in favor of the bulls, meaning that I don't think the wedge will be broken to the downside.