KKDN PP14048/11/2008 (006841)

Trading Smart with

TECHNICAL
Analysis

CIMBs Trading Smart With Technical Analysis [ 1 ]

Contents
1. Fundamental vs. Technical Analysis ................................................... 3
Never shall the twain meet? .................................................................................. 3
Fundamental analysis ........................................................................................... 3
Technical analysis ................................................................................................. 4
Shopping analogy to explain the differences ......................................................... 4
Marrying the two techniques ................................................................................. 4
2. Principles of Technical Analysis ........................................................... 5
Three main principles: ........................................................................................... 5
A chartists toolkit .................................................................................................. 6
Candlestick chart..................................................................................................10
Point & figure chart...............................................................................................11
Conclusion ...........................................................................................................12
3. Candlesticks ...............................................................................................13
How did it all start? ...............................................................................................13
Vital relationship between open and close ...........................................................13
Interpretation of candles.......................................................................................14
Conclusion ...........................................................................................................26
4. The trend is your friend...........................................................................27
Trend, trend, trend ............................................................................................27
Three types of trend .............................................................................................27
Support & resistance ............................................................................................28
Trend, your friend? ...............................................................................................30
Conclusion ...........................................................................................................34
5. Continuation chart patterns ..................................................................35
Practice makes perfect.........................................................................................35
Continuation patterns ...........................................................................................35
Triangles ..............................................................................................................36
Flags and pennants..............................................................................................40
Flags meet me halfway .....................................................................................40
Pennants/wedges.................................................................................................41
6. Reversal chart patterns ..........................................................................43
Gap gift of the gap?...........................................................................................51
7. Oscillators ...................................................................................................56
Moving average convergence divergence (MACD) ..............................................57
Relative strength index (RSI) ...............................................................................60
Using trend lines with oscillators ..........................................................................64
Moving averages ..................................................................................................67
8. Elliot Wave Principle ................................................................................71
View scale ............................................................................................................79
Using MACD with Elliot Wave Principle ...............................................................82
Checklist ..........................................................................................................83

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1
Fundamental vs. Technical Analysis
Two is better than one

Never shall the twain meet?

There are basically two main schools of thought in analysing securities, i.e. fundamental analysis and
technical analysis. Some say that fundamental analysis is the cornerstone of investing. In fact, some would
also say that if you do not practise fundamental analysis, you are not really investing. However, technical
analysts rebuttal is that the market has already discounted all the fundamental factors. To outperform, the
price trend is more important. Timing is everything in technical analysis.

Fundamental analysis
So what is fundamental analysis? Fundamental analysis tries to measure the intrinsic value of a security by
examining its economic, financial and other qualitative and quantitative factors. Investors compare this
intrinsic value with the securitys current price in order to determine what position to take.

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Technical analysis
Technical analysis or charting, as it is sometimes known as, uses an entirely different approach. A technical
analyst or chartist uses historical prices and volume to try to forecast price movements. He totally ignores the
intrinsic value of the security and is only interested in price movements.
Both an art and science? Technical analysis is an art as well as a science. It is an art because it is very
subjective. Two different chartists could interpret the same chart quite differently. Technical analysis is also a
science because the indicators employed by chartists are mathematical or statistical-based formulas or
calculations. These indicators are usually derived from the price (opening, high, low and close) of the security
as well as its trading volume.
No holy grail. We cannot stress enough that technical analysis deals with probabilities and not certainties.
There is no single indicator or pattern with a 100% success rate and there are always some risks involved.
The upshot is technical analysis is no holy grail for making money in the markets. However, an investor who
is careful, patient and disciplined can find success using the principles of technical analysis.

Shopping analogy to explain the differences

Investopedia.com uses an interesting analogy to explain the differences between the two approaches. In a
shopping mall, a fundamental analyst would go to each store, study the product being sold and then decide
whether to buy it or not. In contrast, a technical analyst would sit on a bench in the mall and watch people go
into the stores. Disregarding the intrinsic value of the products in the store, his or her decision would be based
on the patterns or activities of people going into each store.

Marrying the two techniques

There is now a new generation of investors who use both technical and fundamental analysis to buy/sell
equities, currencies, commodities, futures and options, having concluded that:
1. Fundamental analysis shows us WHAT TO BUY
2. Technical analysis shows us WHEN TO BUY.

As such, the investor gets the best of both worlds.

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2
Principles of Technical Analysis
Even a thousand mile journey begins with the first step

Three main principles:

1. The market discounts everything
Technical analysis assumes that the market price has already discounted all factors which would have a
material impact on the security. This is a major criticism that proponents of fundamental research level at
technical analysis, i.e. that it ignores fundamental factors such as the companys fundamentals or the broader
economic factors and only considers price movements.

2. Prices move in trends

Once a trend is determined, prices are more likely to go in the same direction as the trend rather than against
it. Most technical strategies are based on this assumption. As the saying goes, The trend is your friend.

3. History tends to repeat itself

This is related particularly to price movements and patterns. The repetitive nature is due to mass market
psychology where market players often provide consistent reaction(s) when faced with similar market
situations. This consistent reaction creates similar patterns on charts. Greed and fear are two most common
reactions. Charts which are over 100 years old are still relevant in todays markets as they illustrate patterns
in price movements that often repeat themselves, influenced by human emotions and behaviour.

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A chartists toolkit
The main tool charts. Chartists study market action and look for trends and repetitive patterns. Their goal
is to make money from trading these trends and patterns. In the old days, pencil and paper were all that were
needed for charting. Charting appeals to visually oriented people. By plotting the data by hand, they were able
to get a feel of the market. But in these days of personal computers, computers do all the hard work,
causing some chartists to lose some of the feel.

So how do chartists feel the market?

There are four popular ways of plotting data on a chart:
1. Line chart
2. Bar chart
3. Candlesticks chart
4. Point and figure chart

This book gives brief descriptions of all the charts and goes in depth only on candlesticks.

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Line chart
This is the most basic chart and is generally created by drawing a line from one closing price to the next
closing price to the subsequent closing price and so on. When strung together with a line, the general price
movement of a security over a period of time can be seen.

2.1: Daily line chart for Japans Nikkei 225 Index

Source: Bloomberg

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Bar chart
This is one of the more widely used charts in technical analysis. It is mainly an extension of the line chart. By
adding several key components such as the open, the high and the low to the close, we can create a bar
chart. The bar chart is made out of a series of vertical lines that contains all the key components. It is a visual
representation of price activity over a given period of time and is used to spot trends and patterns. Bar charts
are also sometimes known as OHLC charts.

Below are examples of price bars:

HIGH HIGH

CLOSE OPEN

OPEN
CLOSE

LOW LOW

Open: The opening price

High: The highest price of the time period
Low: The lowest price of the time period
Close: The closing price of the time period

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2.2: Daily bar chart for Dow Jones Industrial Average

Source: Bloomberg

2.3: Hourly candlestick chart for Malaysias Gamuda

Source: Bloomberg

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Candlestick chart
Candlestick charts show the same information as bar charts but differ in the ways they are visually
constructed. Some chartists prefer candlesticks as they are easier to interpret, making it easier for beginners
to pick up charting. Some also consider these charts to be more appealing to the eye. Below is a brief
description of how candlesticks are constructed. We will delve deeper into candlesticks in the next chapter.
Constructing the candlesticks. Similar to bar charts, candlesticks require data of the opening price, the high
of the day, the low of the day and the closing price. Emphasis is on the opening and closing prices. The
hollow or filled portion of the candlestick is called "the body", which is also known as "the real body".
The long thin lines above and below the body represent the high/low range and are called "shadows", which
are also known as "wicks" and "tails". The high is marked by the top of the upper shadow and the low by the
bottom of the lower shadow.

Here are some examples of candlestick bars:

White Candle Black Candle

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Point & figure chart
Point & figure charts are not widely used by the average trader/investor although these charts have a long
history. They differ from "normal" price charts in that they completely disregard the passage of time and only
chart the changes in prices. The point and figure chart removes the noise or insignificant price movements
in the stock, which can distort the traders views of the price trends. These types of charts also try to
neutralise the skewing effect that time has on chart analysis.

2.4: Point and figure chart for Australias All Ordinaries

Source: Metastock

Price advances are noted with a X and price declines are marked with an O on point and figure charts.
Each box on the chart represents the price scale, which adjusts depending on the price of the stock the
higher the stock's price, the more each box represents. Note that no Xs or Os are drawn if prices rise or fall by
an amount that is less than the box size. There are also numbers and letters in the chart; these represent
months and give investors an idea of the date.
The reversal criteria are another critical point in point and figure charts. Usually, these reversal criteria are set
at three but can also be set according to the chartist's discretion. The reversal criteria set how much the price
has to move away from the high or low in the price trend to create a new trend. In other words, the reversal
criterion is how much the price has to move so that it can become a column of Os after a column of Xs, or
vice versa. When the price trend has moved from one trend to another, it shifts to the right, signalling a trend
change.

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Conclusion
No technical analysis without charts!
It is the essential that the chartist is able to comprehend and interpret what is being shown on the chart and
the information behind it. In the next chapter, we will focus more on candlestick charting. Not many realise
that candlesticks were first used in Japan more than 100 years ago.

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 3
Candlesticks
The beginning is the most important

How did it all start?

The candlestick techniques that chartists use today originated from the style of technical charting used by the
Japanese for over 100 years, way before the West developed the bar and point-and-figure charts. According
to Steve Nison, author of Japanese candlestick charting techniques, this form of charting first appeared
sometime after 1850.
A Japanese rice trader named Homma discovered and used this form of charting to measure market
emotions towards the trading of rice. It is likely that his original ideas were modified and refined over many
years of trading, eventually resulting in the system of candlestick charting being used today.

Vital relationship between open and close

The relationship between the open and close is considered vital information and forms the essence of
candlesticks. Hollow candlesticks or white candlesticks, where the close is greater than the open, indicate
strong buying pressure. Filled candlesticks or black candlesticks, where the close is less than the open,
indicate strong selling pressure. Instead of using black and white candles, some charting software use green
candlesticks for hollow candlesticks and red candlesticks for filled candlesticks

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Interpretation of candles
A white candle is known as Yo. It is essentially bullish, i.e. the bulls won the session. A white candle is
where the close is greater than the open. Conversely, the black candle is called In. It is essentially bearish,
i.e. the bears won the session.
Generally speaking, the battle between bulls (buyers) and bears (sellers) over a given period of time is
illustrated in a candlestick. A long body show the high intensity of the buying or selling pressure. Conversely,
short candlesticks indicate little price movement and represent consolidation.

White = buying pressure. A long white candlestick suggests strong buying pressure. The rationale behind
this is that if prices have advanced significantly from the open to the close, the buyers are aggressive. Usually
a long white candle suggests bullishness but one has to still read it with the broader technical picture in mind.
After extended declines, long white candlesticks can mark a potential turning/reversal point or support level.
On the other hand, a strong and prolonged period of advance could mean excessive bullishness and the
possibility of a pullback or correction in the coming periods.
Black = selling pressure. A long black candlestick suggests strong selling pressure. Similarly, the
bearishness of the long black candlestick depends on the broader technical picture. The long black
candlestick can mark a turning point or a future resistance level after extended advances. After drawn-out
declines, the long black candlestick is a good indicator of panic or capitulation.

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Marubozu
There are more persuasive long candlesticks called the white or black Marubozu. The Marubozu brothers
have no shadows on either sides of their bodies. A white Marubozu indicates that buyers basically drove
prices up from the open all the way to the close, where it ends at its high. A black one has the exactly
opposite interpretation, whereby sellers pushed prices lower throughout the session to close at the low.

White Marubozu Black Marubozu

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Spinning tops
Shadows on candlesticks can provide valuable insights into the trading session. Upper shadows represent the
sessions high and lower shadows the sessions low. Candlesticks with short shadows indicate that most of
the trading action was confined near the open and close, i.e. a tight band. Candlesticks with long shadows
show that trades extended well past the open and close.
Spinning tops are candlesticks that have small bodies with both the upper and lower shadows greater in
length than the body. It usually signifies indecision. Regardless of its colour, they are usually considered a
neutral pattern in trading ranges. However, after a long advance or long white candlestick, a spinning top
indicates weakness among the bulls and a potential change or interruption in trend. After a long decline or
long black candlestick, a spinning top indicates weakness among the bears and points to a possible change
in trend.

White Spinning Top Black Spinning Top

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The magical doji?
In Steve Nisons Japanese Candlestick Charting Technique, there is a chapter solely on what he calls a
magic doji. A doji is a candlestick in which the opening and closing prices are the same or almost the same.
It shows that the market is in equilibrium, where bulls are equal (or almost) to the bears. Nison believes that
the doji is a significant reversal indicator. Below are several types of doji:

Doji Long-legged Doji Gravestone Doji Dragonfly Doji

A long-legged doji has a relatively long upper and lower shadow with a minimum body. It tells of a great deal
of indecision.
Gravestone doji is formed when the open, low and close are equal while the high creates the long upper
shadow. It has a minimum body at the low end of the days trading range with no lower shadow. This doji
shows that the bulls were stronger earlier in the period where they dominated trading and nudged prices
higher. Later, sellers emerged and drove prices back to the opening level and the sessions low. The longer
the upper shadow, the more bearish the implication of the gravestone doji. It is even more so after a
significant rally.
Dragonfly doji is formed when the open, high and close are equal while the low creates the long lower
shadow. The candlestick looks like T with a long lower shadow and no upper shadow. The dragonfly doji
means that the sellers drove prices down early before the buyers lifted the prices back to the opening and the
sessions high. It is the direct opposite of the gravestone Doji. Similarly, it is a more bullish signal, particularly
at the end of a downtrend.

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Reversal signals hammer away!
Here are two of the more popular long shadow reversal patterns. They are two pairs of single candlestick
reversal patterns made up of a small real body, one long shadow and one short or non-existent shadow.
Generally, the long shadow, which can be either black or white, should be at least twice the length of the
body. It is the location of the long shadow and preceding price action that determine the classification,
regardless of the colour of the body.

Hammer and Hanging Man Shooting Star and Inverted Hammer

The first pair, hammer and hanging man, consists of identical candlesticks with small bodies and long lower
shadows. The second pair, shooting star and inverted hammer, also contains identical candlesticks, except,
in this case, they have small bodies and long upper shadows.
The hammer and hanging man look exactly the same while the shooting star and inverted hammer also look
similar. But each candlestick has different implications based on the preceding price action. Shooting star is
actually an inverted hanging man while an inverted hammer is obviously the opposite of a hammer.

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The hammer is a bullish reversal pattern that follows a steep decline. In addition to a potential trend reversal,
hammers also reveal bottoms or support levels. However, it is important to wait for bullish confirmation as the
low of the hammer shows that plenty of sellers remain. Further buying pressure, and preferably on expanding
volume, is needed before acting. Such confirmation could come in a form of a gap up or long white
candlestick. In selling climaxes, hammers appear quite frequently. Look out for heavy volume as it increases
the validity of the reversal.

The hanging man, however, is a bearish reversal pattern that can also mark a top or resistance level. It
usually forms after an advance shows that selling pressure is on the rise. This pattern alerts the chartist to a
potential turnaround. Similarly, it requires further confirmation. The confirmation could be in a form of a gap
down or a long black candlestick on heavy volume.

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The shooting star is a bearish reversal pattern that forms after an advance and is in the star position (see Star
family below), hence its name. A shooting star can mark a potential trend reversal or resistance level. The
yellow flag is raised when the bears are aggressive in dragging prices down from its highs (long upper
shadow) after a big advance. The upper shadow should be relatively long. Bearish confirmation is required
after the shooting star and can take the form of a gap down or long black candlestick on heavy volume.

An inverted hammer looks exactly like a shooting star but forms after a decline or downtrend. Inverted
hammers represent a potential trend reversal or support levels. The bulls tried to regain control but were
unable to sustain buying pressure, as suggested by the long upper shadow. Because of this failure, an
inverted hammer needs to be followed by a gap up or a long white candlestick with heavy volume that could
act as bullish confirmation.

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Engulfing patterns. This pattern typically follows a very fast trend move. A reversal pattern can be bearish or
bullish, depending on whether it appears at the end of an uptrend (bearish engulfing pattern) or a downtrend
(bullish engulfing pattern). This pattern is characterised by a long body that engulfs the prior periods small
body. Shadows are not relevant in these patterns. The engulfing period usually has very high volume. This
signal is usually not visible on a bar chart.

Bullish engulfing pattern Bearish engulfing pattern

Star family patterns. A candlestick that gaps away from the prior candlestick is said to be in star position.
The first candlestick usually has a large body, but not always, while the second candlestick (in star position)
has a small body. The two candlesticks can be any combination of white and black. We have already seen a
sample of the star family in the form of a shooting star pattern. Dojis, hammers and spinning tops have small
real bodies and can also form in the star position.

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Evening doji star is a three-day bearish reversal pattern. It is a major top reversal signal and is considered to
be more bearish than the evening star pattern because of the doji. On the first day, a large white body is then
followed by a doji that gaps above it, which forms the doji star. The third candlestick is a black body that
closes below the midpoint of the (white) body of the first day.

Evening star is a bearish reversal pattern. It is also a major top reversal signal where an uptrend is continued
with a long white body day. The following day is a gapped up small body day, followed by a down day with the
close ending below the midpoint of the first day.

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Morning doji star is a three-day bullish reversal pattern that looks very similar to the morning star. However,
it is considered to be more bullish than the usual morning star pattern. The first day is in a downtrend with a
long black body. The next day opens lower with a doji that has a small trading range. The last day closes
above the midpoint of the first day.

The morning star is a three-day bullish reversal pattern consisting of three candlesticks. First is a long-bodied
black candle which extends the current downtrend. It is followed by a short middle candle that gapped down
on the open. On the third day, a gapped up long-bodied white candle is observed. The white candle ought to
close above the midpoint of the body of the first day. The morning star is a major bottom reversal signal.

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A candlestick that comes after a larger body is known as a harami pattern. Harami means pregnant in
Japanese and the second candlestick is nestled inside the first. The first candlestick usually has a large body
while the following days candle has a smaller body than the first. The shadows (high/low) of the second
candlestick need not be enclosed within the first, though it is preferable if they are. Doji and spinning tops
have small real bodies and can form in the harami position as well.
Harami patterns imply that a sentiment change is looming. The smaller the body of the second candlestick,
the greater the sign of a reversal on the horizon.

Bullish Harami Bearish Harami

Harami cross is similar to the harami pattern. The only difference is that the final day is a doji.

Bullish Harami cross Bearish Harami cross

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3.1: Candlestick chart for Hong Kongs Hang Seng Index (2001)

Shooting star

Bullish Harami Bullish engulfing

Source: Bloomberg & CIMB/CIMB-GK

3.2: Candlestick chart for US S&P500 Index (2002-2003)

Double spinning tops

Doji
Doji

Hammer
Doji

Source: Bloomberg &CIMb/CIMB-GK

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Conclusion
The highs and the lows of candlesticks are relatively unimportant. Chartists who use candlesticks tend to
focus on the relationship between the opening and closing prices and on patterns based on a single or
several candlesticks. The main advantage of a candlestick chart is its focus on the struggle between
amateurs who control openings and professionals who control closings. Reading candlesticks is pretty similar
to reading bar charts. However, some analysts consider it to be more fascinating, even addictive.
Patience is a great virtue. Chart reading requires practice, lots and lots of it. One can learn the patterns for a
long time and still only scratch the surface of the art. To interpret the patterns well, one needs to understand
the dynamic and complex relationship of many patterns all at once. It is like juggling six pins instead of three.
In the next chapter, we will be discussing one of the most important topics trend. As the saying goes, the
trend is your friend.

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 4
The trend is your friend
The trend is your friend except at the end when it bends Ed Seykota

Trend, trend, trend

Just like location, location, and location in the real estate business, the most important factor in technical
analysis is trend, trend, and trend. Technical analysis is built on the assumption that prices move in trends.

Three types of trend

1. Uptrend
2. Downtrend
3. Sideways trend.

Up, up and away An uptrend is often described as a series of higher highs and higher lows. Falling peaks
and falling troughs constitute a downtrend. A sideways trend or trading range is generally characterised by
horizontal peaks and troughs. The challenging part is determining which trend prices are in currently.
However, before we go on more about trends, one needs to first understand the basic but important concept
of support and resistance.

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Support & resistance
Support and resistance is one of the most widely used concepts in trading. Strangely enough, everyone
seems to have his own idea on how support and resistance should be measured. Alexander Elder uses the
analogy of a ball. A ball hits the floor and bounces. It drops after it hits the ceiling. Support and resistance are
like a floor and a ceiling.
Support and resistance represent key junctures where the forces of supply and demand meet. In the financial
markets, prices are driven by imbalances between supply (down) and demand (up).
Supply is synonymous with bears and selling. Demand is synonymous with bulls and buying. These terms are
used interchangeably throughout this book. As demand increases, prices advance and as supply increases,
prices decline. When supply equals demand, prices move sideways as bulls and bears slug it out for control.

4.1: Basic support and resistance chart

Source: CIMB/CIMB-GK Research

In the chart above, the zigzag pattern is making its way up (uptrend chart). When the market moves up and
then retreats, the highest point reached before the pullback is known as resistance. Resistance is a price level
where sellers are strong enough to overwhelm the buying, causing the uptrend to halt temporarily.
As the market advances again, the lowest point reached before it starts to climb again is known as support.
Support is a price level where buying is strong enough to interrupt or reverse a downtrend. These supports
and resistances are continually formed as the market oscillates over time. Of course, the reverse is true on a
downtrend.

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Support = Resistance. Areas of support and resistance often switch roles. For example, once the support
level gives way, the broken support level can turn into resistance. When the support caves in, it means that
the forces of supply have overcome the forces of demand. Hence, if price revisits that level, there is likely to
be an increase in supply around those levels (sellers who missed out on selling in the first place and new
sellers who want to short the market), forming a resistance. Similarly, if prices breach a resistance, the
resistance turns into a support.

4.2: FTSE Bursa Malaysia MESDAQs daily candlestick chart

Support turned resistance

Support

Sell if break below previous low

Source: Bloomberg & CIMB/CIMB-GK

Long term more meaningful. Support and resistance on longer-term charts are more important than those
on shorter-term charts. Weekly support and resistance levels are usually more relevant than daily ones.
The strength of these support/resistance lines increases each time prices touch the lines and bounce away. A
support line which has about 3-4 tests is usually considered a strong support line while a support line with a
minimum of two tests is a weak support line.
Now, we can move on to trends, one of the most important topics in this book.

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Trend, your friend?
Identifying trends is easier said than done. Identifying trends is one of the hardest things to do in technical
analysis. Trends tend to stand out in historical charts. Experts show those charts at seminars and make it
appear easy to catch trends. On hindsight, it is easy to analyse as the past is fixed. However, in reality, things
are easier said than done.
Where do we start? When does one trend stop and another trend begin? In the chart below, we see three
types of trends in a single chart. But which one should we follow? The main idea is to pick the right trading
strategy within a trend a strategy for short, medium or long term.
One can trade the short-term uptrend within a medium-term downtrend, for example. One can also short the
market (where shorting is permitted) in a medium-term downtrend, which is within a long-term uptrend. It is all
down to your own trading strategy.

4.3: Weekly candlestick chart for Malaysias KLCI

Downtrend within a major uptrend

Uptrend within a
major uptrend
Sep 11

Sideways
trend

Major uptrend line

Source: Bloomberg & CIMB/CIMB-GK Research

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Prices often appear to travel along invisible roads. A trend line is a straight line that connects two or more
price points and then extends into the future to act as a line of support or resistance. It is probably the most
common form of technical analysis used today.
In its most basic form, an uptrend line is drawn along the bottom of easily identifiable support areas (troughs).
We use troughs to identify an uptrend because the peaks tend to be expansive and uneven affairs in
uptrends. The declines tend to be more orderly and when you connect them with a trend line, you get a more
accurate picture of that uptrend.
On the other hand, in a downtrend, the trend line is drawn along the top of easily identifiable resistance areas
(peaks). The panic among weak holders can make the troughs irregular in a downtrend.

4.4: US$-Singapore Dollars daily candlestick chart

Downtrend resistance line

Uptrend support
line

Source: Bloomberg & CIMB/CIMB-GK Research

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To create an uptrend (ascending) channel, draw a parallel line at the same angle as an uptrend line and then
move that line to where it touches the most recent peak.
To create a downtrend (descending) channel, simply draw a parallel line at the same angle as the downtrend
line and then move that line to where it touches the most recent valley.

4.5: US$-Singapore Dollars daily candlestick chart

Uptrend channel with

parallel trend lines

Downtrend channel with

parallel trend lines Sideways channel with
parallel trend lines

Source: Bloomberg & CIMB/CIMB-GK Research

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As mentioned above, it takes two or more points to draw a trend line. The more points of contact the trend line
has with prices, the more valid it is. But it is not always possible to draw trend lines on every price chart even
though it is an important aspect in technical analysis. It is best not to force the issue if there is no clear path to
draw. The general rule in technical analysis is that it takes two points to draw a trend line and the third point
confirms the validity.

4.6: MSCI Asia Ex Japan Indexs weekly candlestick chart

Second point

First point

Fourth point further strengthens

the validity of the trend line

Third point confirms the validity of the

trend line

Source: Bloomberg & CIMB/CIMB-GK Research

CIMBs Trading Smart With Technical Analysis [ 33 ]

There is an inverse relationship between the steepness of a trend line and the validity of the support or
resistance level. A steep trend line occurs when there is a sharp advance (or decline) over a brief period of
time. The sharp move is likely to create a steep angled trend line. This trend line would not be a meaningful
support or resistance level even if the trend line had three valid points. Investors who try to trade the trend line
breakout (up or down) are likely to encounter a lot of difficulty.

4.7: Weekly candlestick chart for Hong Kongs Hang Seng Index

Sharp angle, weak support

trend line, not sustainable!

Strong support trend line

Very strong support trend line

Source: CIMB/CIMB-GK Research

Conclusion
Trend lines offer a lot of information only if used properly. While trend lines have become a very popular
aspect of technical analysis, it is but one of the many tools used for establishing, analysing and confirming a
trend. It should be used as a tool that triggers the alarms (when the trend line breaks) and should not be the
final judge in confirming a change in trend. By using these trend line breaks as warnings, investors and
traders could look for confirmation signals using other technical indicators.

CIMBs Trading Smart With Technical Analysis [ 34 ]

5
Continuation chart patterns
A pattern paints a thousand words

Practice makes perfect

In technical analysis, one could say that a pattern paints a thousand words. Chartists often look for subtle
patterns to identify whether the trend is going to continue or turn around. These patterns are signs that are
usually visible if one knows what to look for.

Not everyone sees these patterns straightaway as pattern identification takes practice and a little
imagination. Chart patterns are simply more complex versions of trend lines. They can be categorised into
two groups continuation and reversal patterns. In this chapter, we will take a look at continuation patterns.

Continuation patterns
Continuation patterns indicate that buying or selling pressure is taking a pause. If a long-term trend is well-
established, the patterns show that it will resume its trend after the pause. Hence, it is advisable to trade
according to the direction of the current trend and not against it. Continuation patterns consist of mainly
triangles, flags and pennants.

CIMBs Trading Smart With Technical Analysis [ 35 ]

Triangles
Triangles are congestion areas where the upper and lower boundaries/lines converge as they are extended to
the right. The point where the two lines meet is called an apex. Triangles can serve either as a continuation
pattern or a reversal pattern. Triangles can be divided into three types:
1) Symmetrical triangle
2) Ascending triangle
3) Descending triangle

Symmetrical triangles
The symmetrical triangle contains at least two lower highs and two higher lows. When these points are
connected, they form two converging lines. The lines have about the same angles. For example, if the upper
line slopes 45 degrees from the horizontal, the lower line should also roughly incline 45 degrees.

5.1: Daily candlestick chart for Malaysias KLCI

Major breakout

Symmetrical triangle

Source: Bloomberg & CIMB/CIMB-GK

CIMBs Trading Smart With Technical Analysis [ 36 ]

Ascending triangle a bullish sign
A triangle, whose lower line has a steeper slope than its higher line, is called an ascending triangle. While
investors may be worried that the price is not making new highs, note that the lows are getting higher. This
shows that the bulls are getting increasingly eager and are willing to pay a higher price, creating a bullish
expectation. Hence, a breakout on the upside is the most likely conclusion.

5.2: Candlestick chart for South Koreas KOSPI Index

Breakout, end of consolidation

Resistance trend line

Ascending triangle

Source: Bloomberg & CIMB/CIMB-GK

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Descending triangle a bearish sign
The mirror image of an ascending triangle is the descending triangle. A descending triangle is a triangle with a
relatively flat lower line and a falling higher line. The lower highs suggest that the bears are getting stronger.
This implies that there is a higher probability of a breakdown and a continuation of the downtrend.

5.3: Daily candlestick chart for UKs FTSE 100

Descending triangle
Support trend line now
becomes resistance

Support trend line

Support trend line broken

Source: Bloomberg & CIMB/CIMB-GK

CIMBs Trading Smart With Technical Analysis [ 38 ]

Volume confirmation for triangle breakouts
As a triangle extends and the trading range contracts, one should find that the volume begins to fall. This is
the calm before the storm or the tightening consolidation before the breakout. An expansion of trading
volume would confirm the breakout or breakdown. Volume confirmation is ideal but it is not always necessary.
Triangles provide a minimum target for a move following a breakout. Measure the height of a triangle at its
base and project vertically from the point where the breakout took place. The minimum measurement is likely
to be exceeded if it is in a strong uptrend.

5.4: Daily candlestick chart for South Koreas KOSPI

Triangle breakout minimum target hit!

Breakout on increasing volume

Source: Bloomberg

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Flags and pennants
Flags meet me halfway
Flags and pennants are short-term continuation patterns that mark a small consolidation before the prior trend
resumes. There is an old saying that goes Flags (or pennants) fly at half-mast. They usually form midway in
a trend. One can measure the distance already moved from the start of the trend and project it from the
breakout or breakdown level to estimate the end of the trend.
A flag is a small rectangular pattern that slopes against the prior trend. If the previous move was up, then the
flag would slope downwards. If the move was down, then the flag would slope upwards. Since flags are
formed in a short period of time, they are unlikely to have reaction highs and lows. As long as the price action
is enclosed within two parallel trend lines, it can be drawn as a flag.

5.5: Soybeans daily candlestick chart

Flag pattern flying at half mast

Source: Bloomberg & CIMB/CIMB-GK

CIMBs Trading Smart With Technical Analysis [ 40 ]

Pennants/wedges
A pennant or wedge is a small symmetrical triangle whose lines are slanted in the same direction, forming a
cone-like pattern. Pennants that are continuation patterns slant against the trend, similar to the flags
characteristics. On the other hand, pennants which slant in the direction of the trend hint of exhaustion,
whereby it is coming to an end of a trend. Pennants are also sometimes known as diagonal triangles. In short,
regardless of the type, whether reversal or continuation, a falling pennant is regarded as a bullish sign while a
rising pennant is bearish.

5.6: US$-s daily candlestick chart

Pennant or wedge a continuation

pattern

Source: Bloomberg & CIMB/CIMB-GK

CIMBs Trading Smart With Technical Analysis [ 41 ]

5.7: US$-New Zealand Dollars weekly candlestick chart

Bearish rising wedge

formation rising in the
direction of the trend which
resulted in a sharp reversal

Bearish breakdown from its rising

wedge

Source: Bloomberg & CIMB/CIMB-GK

During the advance or decline prior to the formation of the flag, the trading volume should be heavy. Heavy
volume provides legitimacy for the sudden and sharp move that creates the flagpole. Volume is likely to fall
during the formation of the flag. Volume expansion on the breakout of resistance (or support) would lend
credibility to the formation and increase the probability of continuation.
It is important that flags and pennants are preceded by a sharp advance or decline. If there isnt one, then the
risk of this formation being a failure increases as the reliability falls. To increase the sturdiness of the pattern,
look for volume confirmation on the initial move, then consolidation, followed by another expansion.

Widening triangles
A widening triangle is a formation where the highs get higher and the lows get lower. This pattern is seen on
uptrends only. It suggests that the market is near the summit where volatility is high. New bulls and bears are
attracted to it and continue to throng in. But as the fight becomes overly intense, it kills the uptrend
momentum, stopping the trend in its tracks and causing the trend to reverse.

Diamonds
Diamonds start out as a widening triangle and end as a symmetrical triangle. Like real diamonds, they are very
rare. They are found at market tops and act as a harbinger of a reversal.

CIMBs Trading Smart With Technical Analysis [ 42 ]

6
Reversal chart patterns
What goes up must come down

In this chapter, we look at reversal patterns. Reversal patterns include double tops and bottoms, triple top and
bottoms, head & shoulders and the inverse head & shoulders. As the name suggests, reversal patterns signal
the end of a trend.

CIMBs Trading Smart With Technical Analysis [ 43 ]

Double top
A double top looks like the letter M. It is a major reversal pattern that forms after an extended uptrend. It
occurs when price rallies again to the area of the previous high on low volume. The second top can be
marginally higher or lower than the first. It need not be exactly parallel to the first top.
In the chart below, you can see that two peaks or tops were formed after a huge rally. Notice how the
second top was not able to break the high of the first top. The failure raises the yellow flag that a reversal is
about to occur as it is telling us that the buying pressure is weakening. Trading volume is usually lower on the
second test of the peak. A break below the neckline support confirmed the validity of this pattern.
Volume plays an important role in determining whether the breakdown is achievable or not. Usually,
increasing volume and momentum off the resistance hints that a breakdown is likely.

6.1: Daily candlestick chart for Malaysias Zelan Holdings

A double top with a rising neckline

Source: Bloomberg & CIMB/CIMB-GK

CIMBs Trading Smart With Technical Analysis [ 44 ]

Double bottom
Double bottoms are the exact opposite of double tops. A double bottom is like the alphabet W. The double
bottom is a major reversal pattern that forms after an extended downtrend. As its name implies, the pattern is
made up of two consecutive troughs that are roughly equal, with a moderate peak in between. Again, trading
volume is lower on the second trough. The confirmation of this pattern occurs when a breakout above the
neckline takes place on increasing volume.

6.2: Daily candlestick chart for Malaysias KLCI (2005)

A double bottom with a flat neckline

Source: Bloomberg & CIMB/CIMB-GK

CIMBs Trading Smart With Technical Analysis [ 45 ]

Triple top
The triple top is a reversal pattern made up of three equal highs followed by a break below the support. Triple
tops take form within a shorter period of time than triple bottoms. In our example below, it took about two
months to complete the pattern. The pattern may look like a double top before the third top takes form.
When looking for patterns, it is important to keep in mind that in this part of technical analysis, it is more art
and less science. It can be very difficult to find a triple top with three highs that are exactly equal. Three
attempts at the resistance, followed by a breakdown below the support backed with volume confirmation,
would do just fine.

6.3: Yen-US$s daily candlestick chart (2002)

A rare triple/quadruple top

Neckline support breakdown

Source: Bloomberg & CIMB/CIMB-GK

CIMBs Trading Smart With Technical Analysis [ 46 ]

Triple bottom
The triple bottom is a reversal pattern made up of three equal lows followed by a breakout above resistance.
Triple bottoms take a few months to form, sometimes even years. Due to its long-term nature, using weekly
charts may be best suited for analysis. Generally speaking, bottoms take longer to form than tops.
The triple bottom is the direct opposite of a triple top. A pick-up in volume on the last leg off the support
increases the chances of resistance breakout. While the triple top or triple bottom is rarer than the double
counterparts, the theory behind them is the same. Both patterns show failure to breach previous highs (or
lows) and they are both reversal patterns.

6.4: Cotton futures weekly candlestick chart (1999)

A triple bottom followed by

a strong rebound

Source: Bloomberg & CIMB/CIMB-GK

CIMBs Trading Smart With Technical Analysis [ 47 ]

Head & shoulders Mother of all reversals
Head & shoulders is also known as the ultimate triple top or the mother of all reversals. Some traders call it
the head and shoulders top as it marks the end of an uptrend. The head is a price peak that is placed in
between two lower peaks, its shoulders. The neckline connects the bottom of the decline from its left shoulder
and the head. There are three types of necklines necklines can be flat, sloping up or sloping down. A
downward sloping neckline usually unleashes the largest downside price move.
45% of the time, prices would pull back to the neckline again on low volume after the breakdown as the
market gives the bulls a last chance to get out before prices fall again. In markets where shorting is permitted,
the pullback is an excellent opportunity to short the market.

6.5: Daily candlestick chart for Malaysias KLCI

H

Head and shoulders with a

declining neckline LS
RS

H&S target
reached!

Source: Bloomberg & CIMB/CIMB-GK

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Volume patterns
Volume patterns are almost similar to the triple top. The volume is lower on the head than on the left shoulder.
It should be even lower on the right shoulder. On the way down from the right shoulder and on the breakdown
from its neckline, volume should start to pick up sharply. The pullback to the neckline is likely to be on low
volume.
Thomas Bulkowski, author of Encyclopedia of Chart Patterns, examined 500 stocks over the 1991 to 1996
period and found that the head & shoulders pattern figured 431 times. Out of the 431 times, 406 of them
resulted in reversals. It is no surprise that the head & shoulder formation is one of the most widely recognised
reversal patterns.
The head & shoulder pattern in the chart above is easy on the eye. But there are times when head & shoulder
patterns are of a complex form and contain other patterns such as a double top or a descending triangle
within them.

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Inverse head & shoulders Head & shoulder bottom
As the name suggests, it is the mirror image of the head & shoulders. Some traders call it the head &
shoulder bottom. This pattern is formed when the downtrend loses its momentum and is ready to reverse. A
head, which is the lowest point, is sandwiched between two higher shoulders. The rally from the head allows
one to draw a neckline. Again, the neckline which is sloping upwards is the most bullish. Prices rally hard from
the right shoulder and break the neckline on increasing volume, completing the inverse head & shoulder
pattern.

6.6: US Dow Jones Industrials daily candlestick chart

Inverse Head and shoulders

with a declining neckline

LS RS

Source: Bloomberg & CIMB/CIMB-GK

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Gap gift of the gap?
Have you ever thought about what causes gaps in price charts and what do they mean? An empty area
between two bars or candlesticks where no trades were done is called a gap. When prices jump in response
to market-moving news such as significantly higher-than-expected earnings being reported after the market
closed, a gap occurs in the next trading session.
Gaps on daily charts usually show the reaction to events that happened during non-market hours. Gaps imply
that something important has happened to the fundamentals or the psychology of the crowd.
Gaps can be subdivided into four categories and each gap tells a different story:
1) Common gap
2) Breakaway gap
3) Runaway gap
4) Exhaustion gap

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Common gaps
Common gaps are also known as trading gaps. They tend to be closed rapidly, i.e. prices return into the gap
within the next few days. Common gaps are usually uneventful and occur in quiet sideways trending markets.
A stock going ex-dividend is an example of common gap. Among the family of gaps, common gaps are the
least useful in terms of trading opportunities as they happen too often for traders to profit from them.

6.7: Common gaps

Exhaustion gap

Common gaps

Runaway gap

Common gap

Source: Bloomberg & CIMB/CIMB-GK

CIMBs Trading Smart With Technical Analysis [ 52 ]

6.8: Other gaps and their positions in rallies

Source: CIMB/CIMB-GK Research

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Breakaway gaps
Breakaway gaps are a bit more exciting. After trading in a tight range or a congestion period, prices jump out
strongly on heavy volume. The price jump is called a breakaway gap. It is usually driven by an event which
induces a great deal of buying or selling. It also shows a major change in the mentality of the masses. This is
usually the starting point of a brand-new trend. The point of breakout now becomes the new support if it is an
upside breakout or resistance if it is a downside breakout. Unlike a common gap, it is unlikely to be closed or
filled any time soon. It sometimes stays open for weeks or months and even years.

Runaway gaps
Runaway gaps are also known as continuation gaps or measuring gaps. They are best described as gaps that
are caused by increased interest in the stock. They occur in the midst of a strong trend, which continue to
reach new highs or new lows without filling the gap.
Runaway gaps are similar to breakaway gaps. The only difference is that runaway gaps happen in the middle
of a trend while breakaway gaps take place at a beginning of a trend. Both of these gaps imply that the bulls
(if the market is bullish) or bears (if the market is bearish) are very keen and are willing to pay higher or lower
prices. The current bull in commodities has plenty of them.
Runaway gaps are also known as the measuring gaps as they are used to help traders gauge how much
longer the trend will last. The theory is that the runaway gap will occur in the middle or halfway through the
move. Sometimes, we see these gaps happening on their own or in a series of gaps and sometimes, they do
not occur at all.
Prices should kick up to new highs or new lows within a few days after the runaway gap. Be wary if they fail to
do so as it could be the perilous exhaustion gap. Runaway gaps are usually followed by a continuing strong
trend whereas an exhaustion gap is followed by more congested, sideways price action.

CIMBs Trading Smart With Technical Analysis [ 54 ]

Exhaustion gaps
At the end of a trend, we sometimes see a last push to new highs or lows, before the trend reverses. The last
push is known as the exhaustion gap. The exhaustion gap is like a tip-off that a reversal is coming. For
example, after several weeks of rallying, the price suddenly gaps up in the direction of the trend. At first
glance, it may look like a runaway gap but it fails to post new highs several days after the gap. Volume starts
to fall and the price reverses and closes the gap.
Alexander Elder likens the exhaustion gap to the last spurt of an athlete in a long distance race. He pulls
away from the crowd but cannot sustain the pace. Soon, the pack closes in on him and you know that he will
lose the race.

Island reversal
A common reversal pattern seen in relation with the exhaustion gap is called an island reversal pattern. A few
days after the exhaustion gap occurs, prices suddenly jump, forming a breakaway gap. A bunch of price bars
are left behind, forming an island-like pattern which is known as an island reversal pattern. A blend of an
exhaustion gap and a breakaway gap is a potent combination signalling that a major reversal is in place.
Traders would be wise to trade against the prior trend.

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7
Oscillators
You never know when you need a helping hand Catherine Pulsifer

Oscillators are one of the most valuable tools for chartists but most of the time, they are misused or
misunderstood. In this chapter, we will discuss two commonly used oscillators, the moving average
convergence-divergence (MACD) and the relative strength index (RSI), and show you how to use them
correctly.

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Moving average convergence divergence (MACD)
Moving average convergence divergence (MACD), which was developed by Gerald Appel, is regarded as one
of the most dependable and technical indicators, combining both oscillators and trend-following indicators. As
such, it is able to measure a markets momentum and also follow its trend.
Consist of two lines. MACD consist of two lines derived from three exponential moving averages (EMA). For
example, in the common setting used in most charting software, the MACD line is the difference between a 12-
period EMA and a 26-period EMA whereas the signal line is a 9-period EMA of the MACD line.
Basic strategy. The basic strategy using MACD is to buy when the MACD line crosses above the signal line
(also known as golden cross) and sell when MACD line crosses below the signal line (also known as dead
cross).
In Figure 7.1, the MACD indicator was effective for the KLCI. However, this is not always the case. Entering
trades just based on the MACD crossover will usually result in frequent whipsaw losses.
Effective in oversold/overbought positions and divergence signals. MACD buy signals should ideally be
exercised at oversold positions supported by positive divergence signals, and MACD sell signals, at
overbought positions supported by negative divergence signals. In Figure 7.2, a divergence with the MACD
indicator and the Hang Seng Index was soon followed by a change in the trend.
Use moving average as your backup stop signal. Investors could use the 21-day simple moving average
(SMA) or 50-day SMA as support or resistance levels. For example, one could sell the stock after confirmation
of the dead cross and also if its share price breaks down below the 50-day SMA.
Not effective MACD is not effective in steadily trending narrow channelled market advances and declines.
In such markets, an investor would need other trading tools to identify strengths or weakness in the direction of
the trend. For example, when the US S&P 500 Index was trading in a narrow uptrend channel from Jun 06
onwards, the MACD signals were not effective then (Figure 7.3).

CIMBs Trading Smart With Technical Analysis [ 57 ]

7.1: KLCIs daily candlestick and MACD indicator chart

50-day SMA

S S
S S
B
B B

S=Sell, B=Buy
B

Source: Bloomberg & CIMB/CIMB-GK

7.2: Candlestick & MACD indicator chart for Hong Kongs Hang Seng Index

Likely bottom, MACD positive divergence,

opportunity to accumulate position

Negative
divergence

Positive divergence

Source: Bloomberg & CIMB/CIMB-GK

CIMBs Trading Smart With Technical Analysis [ 58 ]

7.3: US S&P 500s daily & MACD indicator chart

MACD not effective in narrow

steadily rising uptrend channel

Poor MACD signal

Source: Bloomberg & CIM/CIMB-GK

CIMBs Trading Smart With Technical Analysis [ 59 ]

Relative strength index (RSI)
In 1978, the relative strength index (RSI) was introduced by Welles Wilder Jr. The RSI is a powerful tool when
used in tandem with basic technical analysis methods like trend lines, chart points, resistance and support.

The formula for RSI is:

RSI = 100-[100/(1+RS)]
where RS is the average positive closing changes for specific number of days divided by the average of
negative closing changes for the same number of days. 14 days is commonly used for the RSI.

Overbought and oversold. Generally, overbought and oversold levels are usually set at 70 and 30,
respectively. The most reliable buy sign for RSI is when the indicator records a higher low after a downtrend.

Effective when showing divergence signals. RSI is very effective when the indicator shows negative or
positive divergence. Bullish divergence is when prices make a new low but RSI records a higher low, indicating
a potential buying opportunity.

In a bull market Oscillators like the RSI behave differently in bull and bear markets. In a bull market, an RSI
of 70-80 does not mean the indicator is at overbought levels. The RSI can reach 85-90 before peaking in a bull
market. In a bear market, RSI can peak between 50 and 60 before it reverses its trend.

Effective using trend lines and resistance/support levels. The RSI is also very effective when combined
with trend lines and support/resistance levels. Usually, oscillators like RSI normally break their trend lines and
support/resistance levels before the actual price movement, giving early signals of a major change in the trend.
The next two pages offer some examples on how to use the RSI.

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7.4: KLCIs daily candlestick chart and 14-day RSI indicator

1 3 5
4
2

Resistance trend line now becomes support trend line

Source: Bloomberg & CIMB/CIMB-GK

7.5: Daily candlestick and 14-day RSI indicator for Indonesias Jakarta Composite Index

Triangle consolidation since

end-06. Breakout here

6
8
7

Source: Bloomberg, CIMB/CIMB-GK

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Examples using 14-day RSI
1. RSI peaks only at 85, also a major resistance level. From Aug 06 to Feb 07, RSI does not drop below 50.
2. RSI support trend line broken. Likely indicator of change in the trend.
3. RSI negative divergence from May 07 onwards. KLCI corrects sharply in Jul 07.
4. RSI breakout from resistance trend line, likely indication of the end of its downtrend from the Jul 07 trough.
Resistance trend line becomes support trend line in the next few months.
5. RSI breakout from resistance trend line. KLCI reaches all-time high of 1,524. But not sustainable as RSI
breaks below support trend line (formerly resistance trend line). RSI bottoms at its support trend line in late
Jan 08.
6. Jakarta Composite Index in 4-month triangle consolidation since end-06. RSI breaks out of resistance
trend line in Mar 07. JCI breaks out a few weeks later.
7. RSI support trend line since Mar 07 breaks down. JCI experiences sharp correction.
8. RSI trades in a downtrend channel since Oct 07. A breakout above the upper resistance trend line would
probably indicate the end of JCIs downtrend since the Jan 08 peak
9. RSI negative divergence signal. Possible peak warning ahead. Hang Seng Index peaks in early Nov
before sharp correction.
10. RSI positive divergence signal in Mar, higher RSI low although index reached new low. Hang Seng Index
rallies after Mar bottom.

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7.6: Daily and 14-day RSI chart for Hong Kongs Hang Seng Index

9
Positive divergence

Negative divergence

10

Source: Bloomberg, CIMB/CIMB-GK

CIMBs Trading Smart With Technical Analysis [ 63 ]

Using trend lines with oscillators
Trend lines can also be used for oscillators. Chapter 4 discussed trends and how to use construct and use
the trend lines. From our experience, we find that using trend lines on oscillators like MACD and RSI can give
traders early warning of a likely change in the trend.
Lets take a look at the US S&P 500 Index from Aug 07to May 08. The index peaked at 1,556 in Sep 07 and
corrected until Jan 08. There is a major resistance trend line A-Ai, which the index only managed to break past
in Apr 08.
Early signal. However, the MACD indicator first broke the resistance trend line in Feb 08 before it found
support at that line in March. This MACD breakout usually gives an early signal to investors of a likely end of
the downtrend from the Sep 07 peak. Furthermore, MACD indicated a positive divergence signal, with the
indicator recording a higher trough in Mar than the Jan 08 bottom.
Index significant breakout only in Apr. The RSI recorded a significant breakout from the resistance trend
line only in early March, slightly later than MACDs Feb 08 breakout. However, both MACD and RSI broke out
much earlier than the index itself, which only broke out of the resistance trend line in Apr 08.
Another early warning sign in May. The RSI indicator broke below the support trend line in early May, giving
an early warning sign of a likely change in the uptrend. The S&P500 tested its immediate support trend line
and recorded new highs, only to break down below its support trend line at end-May, a few weeks later than
the RSI support trend line breakdown.

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7.7: US S&P500 Indexs daily MACD & RSI indicator chart
A Strong resistance trend line, broken only here,
MACD broke resistance much earlier

A!

Support trend line broken

MACD positive divergence

RSI breaks major resistance trend line

RSI breaks support trend line

Source: Bloomberg, CIMB/CIMB-GK

Took a little longer. In this chart, the Jakarta Composite Indexs MACD and RSI indicators peaked in Oct 07
and trended downwards. It was showing negative divergence signals as the JCI continued to trend higher and
only peaked in mid-Jan 08, two months after the indicators peaked.
Breakout reflects strength. In Apr 08, both the MACD and RSI broke out of their resistance trend line, a likely
indication of further strength ahead for JCI. True enough, the JCI managed to rally past its major resistance
trend line and also the 50-day SMA in mid-May 08.

CIMBs Trading Smart With Technical Analysis [ 65 ]

7.8: Daily MACD and RSI chart for Indonesias Jakarta Composite Index

50-day SMA Rallies above resistance trend line

MACD& RSI negative divergence since Oct-07

Breakout

Source: Bloomberg, CIMB/CIMB-GK

A word of caution
The main problem with negative and positive divergences by the oscillators is that it would normally take some
time before the actual price or index catches up weeks or months at times. As such, one should use these
oscillators just as early warning signs, not confirmation signals. This strategy using oscillators with support
trend lines and divergence signals can be very effective if practised with some patience.

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Moving averages
One of oldest and reliable indicators. Moving averages (MA) is one of the oldest and most useful technical
indicators in technical analysis. A moving average shows a trend in a smoothed manner and can give reliable
signals when used in tandem with other oscillators like MACD and RSI.
There are basically three types of MA:
1) Simple moving average (SMA)
2) Exponential moving average (EMA)
3) Weighted moving average (WMA)

Commonly used MAs. For stocks, common time periods for MAs are 10 days, 21 days, 50 days, 100 days
and 200 days. The most commonly used MA is the simple moving average (SMA). Single SMAs can be used
to identify a trend but we find that dual or triple MAs are more powerful when combined together.
Depending on an investors investment time horizon and risk appetite, one can use different SMAs.
Short term: combination of the 5-day SMA and 15-day SMA to trade
Medium term: combination of the 21-day and 50-day SMA
Long term: usually use the 200-day SMA or a combination of the SMAs.

Too many false signals. To use the 5-day SMA and 15-day SMA, BUY when the 5-day SMA cuts the 15-day
SMA from below and sell when the 5-day SMA cuts 15-day SMA from above. However, this method can lead
to many false signals. To overcome this problem, one could use oscillators like RSI and MACD to confirm the
BUY or SELL signals (Figure 7.10).

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7.9: Daily candlestick chart (5-day SMA and 15-day SMA) for Malaysias KLCI

S
S S
S B
B
5-day SMA
B B

15-day SMA

Source: Bloomberg, CIMB/CIMB-GK

7.10: Daily candlestick chart (5-day SMA, 15-day SMA, RSI & MACD) for Malaysias KLCI

S S
S
5-day SMA B
B

15-day SMA

Reversal sign!

B B B

B
RSI overbought

RSI oversold RSI oversold

Source: Bloomberg, CIMB/CIMB-GK

CIMBs Trading Smart With Technical Analysis [ 68 ]

50-day SMA reliable medium-term indicator. Generally, the 50-day SMA is a reliable indicator for identifying
medium-term trends. A good example was the KL Property Index in 2007. The index experienced a strong rally
that started in 4QCY06. Every correction found support at the 50-day SMA during that period. Only in Aug 07
did the index crack below the 50-day SMA. Since then, it trended lower until 1QCY08. A SELL signal for a
medium-term trend is when the 21-day SMA cuts 50-day SMA from above and vice versa.

7.11: Candlestick chart (21-day SMA and 50-day SMA) for Malaysias KL Property Index

21-day SMA

Sell signal

50-day SMA

Source: Bloomberg, CIMB/CIMB-GK

CIMBs Trading Smart With Technical Analysis [ 69 ]

Long-term support at 200-day SMA. Most investors use the 200-day SMA as a long-term support trend line.
In the past few years, the 200-day SMA was a strong long-term support trend line for the MSCI Asia ex-Japan
Index (MAxJ). Every major correction found buying support at the 200-day SMA. However, after breaching the
200-day SMA on the downside in Jan 08, the index has been struggling to overcome the 200-day SMA, its
previous support turned resistance level.

7.12: MSCI Asia ex-Japan Indexs daily candlestick chart (100-day SMA & 200-day SMA)
200-day SMA turned
strong resistance now

100-day SMA
200-day SMA strong
support but broken here

BUY signal, 100-day SMA cut

200-day SMA from below
200-day SMA

Source: Bloomberg, CIMB/CIMB-GK

CIMBs Trading Smart With Technical Analysis [ 70 ]

 8
Elliot Wave Principle
Simple is not easy

In the 1930s, Ralph Nelson Elliot, through studying the Dow Jones Industrial Average (DJIA) charts,
discovered that stock market prices trended and reversed in recognisable patterns. Patterns were repetitive in
form but not necessarily in time and amplitude. He isolated 13 patterns and saw how they linked together to
form larger versions of themselves. He called this The Wave Principle. It was later known as the Elliot Wave
Principle (EWP). Under the EWP, every market decision is both produced by meaningful information and also
produces meaningful information. As forms are repetitive, they have predictive value.
Made popular by Pretcher. The person mainly responsible for re-introducing the EWP to the investment
community is Robert Pretcher. In 1976, Pretcher was working as an analyst in Merrill Lynch when he
discovered the complete body of Elliots work in the New York Public Library. In 1978, Pretcher and A.J. Frost
published the Elliot Wave Principle and the rest is history. Today, this book is considered the bible for any
Elliotician and anyone who wants to truly understand the EWP. For more details, check out
www.elliotwave.com.

CIMBs Trading Smart With Technical Analysis [ 71 ]

The Elliot Wave Principle has only three rules and fewer than two dozens guidelines as its framework. The
three unbreakable rules are:
1) Wave 2 will not retrace below the start of Wave 1
2) Wave 3 cannot be the shortest of the impulse waves. Wave 3 might not be the longest but it usually is.
3) Wave 4 cannot overlap peak of Wave 1.

Eight waves to complete one cycle. A major move involves a five-wave pattern, to be corrected by three
waves going in the opposite directions. Numbered phase are called impulse waves while the lettered phase
is called corrective waves. Wave 2 corrects Wave 1, Wave 4 corrects Wave 3 and Wave 1-5 is corrected by
a-b-c waves. This basic wave pattern, in turn, builds to form five and three-wave structures of larger degree.

8.1: Basic Elliot Wave pattern

5
b
3

a
4
1

Source Elliot Wave Principle

CIMBs Trading Smart With Technical Analysis [ 72 ]

This pattern is followed by another similar five upward waves and three downward waves. A third advance
completes a five-wave movement of one degree larger than the waves which it is composed. The peak of
wave 5 is followed by a larger degree three-wave a-b-c correction. To complete the one-degree larger wave
count would require in total 34 sub-waves.

8.2: Complete Elliot wave pattern

Source: Elliot Wave Principle

CIMBs Trading Smart With Technical Analysis [ 73 ]

Corrective waves
The most important rule from a corrective pattern is that corrections are three waves, never fives. Only motive
waves are fives. Corrective processes come in two shapes, sharp or sideways correction. Specific corrective
patterns fall into four main categories:
1) Zigzag (5-3-5 pattern and three types)
2) Flat (3-3-5 pattern and three types)
3) Triangle (3-3-3-3-3 pattern and four types)
4) Combination (eg. double three & triple three)

8.3: Corrective patterns

Zig zag Flat

Triangle Doubles

Source: Elliot Wave Principle

CIMBs Trading Smart With Technical Analysis [ 74 ]

Wave personality
Every wave has its own personality. This brings human behaviour more personally into the EWP. For example,
if an investors feels there is something wrong with this market, it is likely a corrective wave B. Below are the
summary personalities of the waves in a bull market:

Impulse wave 1
Hard to forecast, not much staying power. Usually in a base building process where sellers think that this rally
is the last chance to sell.

Corrective wave 2
Can correct all of Wave 1 but not exceed it. Usually, the market feels as though the bear market is here to
stay.

Impulse wave 3
Normally longer than Wave 1, extension usually 1.618x, 2.618x or 4.236x length of Wave 1. Usually, slope is
rd rd
steeper than Wave 1 and most powerful. Highest volume is usually at 3 wave of a 3 wave. Robert
Prechter calls it a wonder to behold.

Corrective wave 4
Wave 4s are supposed to be predictable due to the principle of alternation (see below for explanation).
However, due to the fact that there are several complex forms of correction, it is sometimes difficult to forecast
which form would take place. Typically, they tend to move in a sideways trend, in preparation for the Final
Wave 5. It should not fall into Wave 1 territory.

Impulse wave 5
Wave 5s are usually similar in length to Wave 1, if Wave 3 is an extended wave, regardless if it is extended by
1.618x or 2.618x. In some cases, an extended wave 5 is 1.618x of the length from the beginning of Wave 1 to
the end of Wave 3, assuming wave 3 is not extended. Investor sentiment is at its most bullish in this wave.
Despite so, the market breath and momentum start to deteriorate.

CIMBs Trading Smart With Technical Analysis [ 75 ]

Wave A
In a bear market, investors generally believe the decline is only a pullback before the next advance and offers
opportunities to buy. Technically, negative cracks start appearing in stocks. A five-wave A indicates zigzag
while a three wave A indicates a flat or triangle consolidation.

Wave B
Regarded as suckers play, phonies and bull trap. Rarely technically strong and only selected stocks rally.

Wave C
Usually destructive, have most of the properties of Wave 3. Sharp declines. Investors fear level is likely to be
at its highest.

Principle of alternation
The guidelines of alternation state that if Wave 2 was a simple correction (zig-zag), Wave 4 correction should
be complex sideways corrections such as flats, triangle or double threes. If Wave 2 corrects 61.8% of Wave 1,
Wave 4 is likely to correct 38.2% of Wave 3 and vice versa.

CIMBs Trading Smart With Technical Analysis [ 76 ]

Fibonacci ratios

The Fibonacci sequence of numbers was discovered by Leonardo Fibonacci da Pisa, a thirteenth century
mathematician. The Fibonacci numbers are 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233 etc.

Adding the two adjacent numbers will yield the next number in sequence, e.g. 13 + 21 = 34 and 21 + 34 = 55.
After the first four digits, dividing a Fibonacci number by the number immediately preceding it will produce the
1.618 ratio. The inverse of 1.618 is 0.618 which is known as the golden ratio. After the first several numbers,
dividing any Fibonacci number with a preceding one also approximately yields 1.618. On the other hand,
dividing the preceding number with any Fibonacci number will approximately yield the inverse 0.618, or the
golden ratio.

Dividing any Fibonacci number which precedes it two places in the sequence will throw up the 2.618 ratio. The
inverse of 2.618 is 0.382.

Dividing any Fibonacci number which precedes it three places in the sequence will lead to the 4.236 ratio. The
inverse of 4.236 is 0.236.

Fibonacci numbers not relevant; key is the ratios. The Fibonacci numbers cannot be used to forecast
market movements in terms of price and time. The key factor is the ratios between the numbers in sequence.
These ratios are the primary factor in forecasting price and time movements in markets.

Common Fibonacci relationship. Common Fibonacci relationships are found between alternate waves. For
example, the length of wave 3 would be influenced by length of wave 1 rather than wave 2. Usually when
length of Wave 3 extends beyond Wave 1, the next projection of Wave 3 would be either 1.618x, 2.618x or
4.236x the length of Wave 1.

Predict corrective waves. To predict corrective waves, the application of Fibonacci ratios of 0.236, 0.382,
0.5, 0.618 or 0.764 to the length of the preceding impulsive wave. For example, Wave 2 usually corrects about
50%, 61.8%, or 76.4% of the length of Wave 1. It could even retrace all the way back to the start of Wave 1
whereas Wave 4 is likely to retrace between 38.2% and 61.8% of the preceding impulsive wave, which is
Wave 3.

CIMBs Trading Smart With Technical Analysis [ 77 ]

8.4: Simple example of Elliot Wave count using Fibonacci ratio

Wave 3 is 1.618x
1 length of wave 1

4
Correct 0.382x
length of wave 3

2 Correct 0.618x
length of wave 1

Source: CIMB/CIMB-GK

CIMBs Trading Smart With Technical Analysis [ 78 ]

Examples of Elliot Wave Principle: KL Composite Index

Major uptrend ended in Jan 08. In the next three charts, we look at the KLCIs wave count at different wave
degrees.

View scale
From end-05, the KLCI completed a major five-wave count to peak at 1,524pts in Jan 08.
Wave i From 883, it rallies 98pts or 9.8% to peak at 970pts in May 06
Wave ii - KLCI erases all gains and retraces back to 883pts in Jun 06 in a simple zig-zag correction
Wave iii - Strong rally to peak at 1,391pts in Jun 07, 508pt gain or 57.5% upswing
Wave iv Followed by sharp correction, loses 250pts, 49.6% decline of length of wave 3, simple zig-zag
correction, alternation principle does not take place.
Wave v Final rally, 383pts or 33.5% rally to peak at 1,524pts in Jan 08.

Observations of the wave count

Wave ii retraces back all the way to the start of wave i.
Wave iii is the longest and strongest among all the three impulsive waves. Wave iii is 5.18x length of wave i.
Wave iv retraces 50% of wave iii, Wave iv usually retraces either 38.1% or 50% of the length of Wave 3.

8.5: KLCIs five-wave medium-term count since 2001

V (1,524)

iii (1,391)

iv(1141)

i(970)

883 bottom ii(883)

Source: Bloomberg & CIMB Research

CIMBs Trading Smart With Technical Analysis [ 79 ]

Part of a larger wave. In the next chart, one can see that the KLCIs rally from end 05 to Jan 08 is only part of
a larger wave count. Global and Asian equity markets bottomed out just after 2001s Sep 11 incident.

Larger view scale

Wave 1 KLCI bottoms out at 547 in Apr 01 and rallies 270pts or 49.3% to peak at 817pts in Apr 02.

Wave 2 KLCI retraces 202pts or 88% of Wave 1 to bottom out at 615pts in Dec 02.

Wave 3 KLCI rallies 909pt or 148% to peak at 1,524pts in Jan 08. Wave 3 is 3.3x length of Wave 1.

Wave 4 KLCI experiences sharp decline, falls 367pts to bottom at 1,157pts in Mar 08. Decline is 40% of the
length of Wave 3. Possible bottom at 1,157pts but this is not confirmed.

Example of alternation principle. In the next chart, KLCIs Wave 3-ii was a simple zig-zag correction. Based
on the alternation principle, Wave-iv must be complex, likely triangle, flat or double threes. Wave 3-iv was a 5-
wave triangle consolidation from Apr 04 to Dec 05.

8.6: KLCIs preferred long-term wave count

v
3(1524)

Wave 4 likely flat, triangle or double

threes? More obvious as correction
takes place in time
4 or 4-A?

wave iv triangle consolidation

iii
1(817)
iv(883)

ii
2(615)
547

Source: Bloomberg & CIMB Research

CIMBs Trading Smart With Technical Analysis [ 80 ]

Correction... the difficult part to forecast

Complex or triangle consolidation? Corrections are usually the hardest to forecast in view of the many
possible alternatives. There are various possible formations like the flat, triangle, complex triangle, zig zag and
flat formations.

Principle of alternation gives us a clue. Elliot Waves principle of alternation says that if wave 2 was a
simple correction (zig zag), wave 4 should be complex sideways corrections, likely flat or triangle. As major
Wave 2 was clearly a simple zig-zag correction, it is likely that major Wave 4 will be complex. However, the
principle of alternation is just a principle and not written in stone. In our experience, this principle does not work
all the time.

CIMBs Trading Smart With Technical Analysis [ 81 ]

Using MACD with Elliot Wave Principle

Investors can also combine Elliot Wave Principle analysis with traditional oscillators like MACD to reaffirm
current wave counts. For example, it is usually easy to identify Wave 3 with the MACD. In a 5-wave move,
there are three MACD signs to watch out:

1) Wave 3 usually leads to an extreme reading in MACD

2) Wave 4 usually test zero levels
3) Wave 5 drives prices higher but MACD reaches a lower peak

In the example below, crude oil price probably reached Wave 3 in early Nov as MACD peaked at these levels.
This was followed by Wave 4 simple a-b-c- zig-zag correction where MACD reached zero. This was then
followed by the Wave 5 peak but the MACD high was way below Wave 3s high.

Combining the wave principle and traditional oscillators offers investors a clear outlook for its prices. If a stock
or commodity is close to completing its wave 5 and this is indicated by the oscillators, one would naturally look
to realise gains before the corrective wave starts.

8.7: Crude oils daily chart with MACD indicator

3 b 5
Wave 3 is 1.618x
length of wave 1

a
1
c 4 Double bottom

Wave 3 likely, Wave 4, MACD

MACD high test zero

MACD lower peak,

likely wave 5

Double bottom

Source: Bloomberg & CIMB/CIMB-GK

CIMBs Trading Smart With Technical Analysis [ 82 ]

 9
Checklist
Better to learn from others mistakes

Step 1
Decide on a method. This is your edge.
Match the trading method to your personality.

Step 2
Establish the direction of the trend.
Look at the monthly, weekly and daily charts. Use trend oscillators like the MACD to establish the long-term,
medium-term and immediate-term trends.

Step 3
Look for major support and resistance trend lines. The more times the line has been tested, the stronger the
trend line is.
Look for continuation or reversal patterns

Step 4
Risk control plan includes:
i) Maximum risk per trade. Ideal maximum risk per trade limited to 5% or less
ii) Stop-loss strategy. Know where you are getting out before you get in.

Step 5
Establish time routine. Set aside time to review investments. Plan new trades or update exit points for existing
positions.

CIMBs Trading Smart With Technical Analysis [ 83 ]

The most important rules in investing:

Rule No.1 - Preserve capital

Rule No.2 Follow Rule No.1

CIMBs Trading Smart With Technical Analysis [ 84 ]

References:
Nison, Steve. 1991. Japanese Candlestick Charting Techniques. New York Institute of Finance
Frost & Prechter. 1999. Elliot Wave Principle. John Wiley & Sons Ltd.
Schwager, Jack. 1996. Schwager on Futures: Technical Analysis. John Wiley & Sons Ltd.
Elder, Alexander. 1993. Trading for a living. John Wiley & Sons Ltd
Elder, Alexander. 2002. Come into my Trading Room: A complete guide to trading. John Wiley & Sons Ltd
www.investopedia.com
Murphy, John J. 1999. Technical Analysis of the Financial Markets . Prentice Hall Press
Pring, Martin J. 2002.Technical Analysis Explained 4th Edition. McGraw Hill
Bulkowski, Thomas. 2000. Encyclopedia of Chart Patterns. Wiley Trading.
Rockefeller, B., Henderson, K., Lovrencic, L., Pontikis, P. 2007. Charting for Dummies (Australian Edition). Wiley
Publishing Australia Pty Ltd.

CIMBs Trading Smart With Technical Analysis [ 85 ]

Notes:

CIMBs Trading Smart With Technical Analysis [ 86 ]

Notes:

CIMBs Trading Smart With Technical Analysis [ 87 ]

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experience relating to investments should not rely on this document.
United States: This research report is distributed in the United States of America by CIMB-GK Securities (USA) Inc, a U.S.-registered broker-dealer and a related
company of CIMB-GK Research Pte Ltd solely to persons who qualify as "Major U.S. Institutional Investors" as defined in Rule 15a-6 under the Securities and Exchange
Act of 1934. This communication is only for Institutional Investors and investment professionals whose ordinary business activities involve investing in shares, bonds and
associated securities and/or derivative securities and who have professional experience in such investments. Any person who is not an Institutional Investor must not
rely on this communication. However, the delivery of this research report to any person in the United States of America shall not be deemed a recommendation to effect
any transactions in the securities discussed herein or an endorsement of any opinion expressed herein. For further information or to place an order in any of the above-
mentioned securities please contact a registered representative of CIMB-GK Securities (USA) Inc.
Other jurisdictions: In any other jurisdictions, except if otherwise restricted by laws or regulations, this report is only for distribution to professional, institutional or
sophisticated investors as defined in the laws and regulations of such jurisdictions.

RECOMMENDATION FRAMEWORK #1*

STOCK RECOMMENDATIONS SECTOR RECOMMENDATIONS

OUTPERFORM: The stock's total return is expected to exceed a relevant OVERWEIGHT: The industry, as defined by the analyst's coverage universe, is
benchmark's total return by 5% or more over the next 12 months. expected to outperform the relevant primary market index over the next 12
months.
NEUTRAL: The stock's total return is expected to be within +/-5% of a relevant NEUTRAL: The industry, as defined by the analyst's coverage universe, is
benchmark's total return. expected to perform in line with the relevant primary market index over the next
12 months.
UNDERPERFORM: The stock's total return is expected to be below a relevant UNDERWEIGHT: The industry, as defined by the analyst's coverage universe,
benchmark's total return by 5% or more over the next 12 months. is expected to underperform the relevant primary market index over the next 12
months.
TRADING BUY: The stock's total return is expected to exceed a relevant
benchmark's total return by 5% or more over the next 3 months.
TRADING SELL: The stock's total return is expected to be below a relevant
benchmark's total return by 5% or more over the next 3 months.

* This framework only applies to stocks listed on the Singapore Stock Exchange, Bursa Malaysia, Stock Exchange of Thailand and Jakarta Stock Exchange.

CIMB-GK Research Pte Ltd (Co. Reg. No. 198701620M)

CIMBs Trading Smart With Technical Analysis [ 90 ]

 RECOMMENDATION FRAMEWORK #2 **

STOCK RECOMMENDATIONS SECTOR RECOMMENDATIONS

OUTPERFORM: Expected positive total returns of 15% or more over the next OVERWEIGHT: The industry, as defined by the analyst's coverage universe, is
12 months. expected to outperform the relevant primary market index over the next 12
months.
NEUTRAL: Expected total returns of between -15% and +15% over the next NEUTRAL: The industry, as defined by the analyst's coverage universe, is
12 months. expected to perform in line with the relevant primary market index over the next
12 months.
UNDERPERFORM: Expected negative total returns of 15% or more over the UNDERWEIGHT: The industry, as defined by the analyst's coverage universe,
next 12 months. is expected to underperform the relevant primary market index over the next 12
months
TRADING BUY: Expected positive total returns of 15% or more over the next 3
months.
TRADING SELL: Expected negative total returns of 15% or more over the next
3 months.

** This framework only applies to stocks listed on the Hong Kong Stock Exchange and China listings on the Singapore Stock Exchange.

CIMBs Trading Smart With Technical Analysis [ 91 ]

 CIMB Securities Offices

CIMB Investment Bank CIMB Securities (S) PT CIMB Securities CIMB Securities (HK) CIMB Securities CIMB Securities (UK) CIMB Securities (USA)
Bhd Pte Ltd Indonesia Ltd (Thailand) Co Ltd Ltd Inc
(18417-M) (198701621D) (01.353.099.3-054.000) (290697) (0105542081800) (2719607) (52-1971703)
(A Participating Organisation of 50 Raffles Place The Indonesia Stock Units 7706-08 44 CIMB 27 Knightsbridge 540 Madison Avenue
Bursa Malaysia Securities Bhd)
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T: +60 (3) 2084 8888 T: +65 6538-9889 T: +62 (21) 515-1330 T: +852 2868-0380 T: +66 (2) 657-9000 T: +44 (20) 7201-2199 T: +1 (212) 616 8600
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