Michael C.

Thomsett
Practical Trend Analysis
ISBN 978-1-5474-1721-6
e-ISBN (PDF) 978-1-5474-0108-6
e-ISBN (EPUB) 978-1-5474-0110-9

Library of Congress Control Number: 2018962686

Bibliographic information published by the Deutsche Nationalbibliothek

The Deutsche Nationalbibliothek lists this publication in the Deutsche
Nationalbibliografie; detailed bibliographic data are available on the Internet at http://
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© 2019 Michael C. Thomsett

Published by Walter de Gruyter Inc., Boston/Berlin
Cover Image: Sergey_P/iStock/Getty Images Plus

www.degruyter.com
Contents
Chapter 1: The Theory of Trends: Dow, EMH, and RMH in Con
text
Five Assumptions about Short-Term Trends
The Beginnings of Trend Analysis: The Dow Theory
The Dow Theory Applied
Other Price Theories: EMH
Types of EMH in Theory
The Bubble Effect
Other Price Theories: RWH
Trend Analysis as a Risk Management Process

Chapter 2: Statistically Speaking: Trends by the Numbers

Fat Tails and Trends
Bollinger Bands
Statistical Tendencies
Trends and Averages
Trends versus Price
Strength and Weakness of Trends
Pattern Cycles
Market Sentiment Expressed in the Trend
Momentum Trading
Statistical Measurements and Trend Behavior Distinguished
Spikes and How to Manage Them
After the Spike: Breakouts and Reversals
Statistical Analysis of Fundamentals
Game Theory Applied to Trend Analysis
 Magical Thinking and Trends

Chapter 3: Resistance and Support: A Trend’s Moment of Tr

uth
Tests of Breadth
The Nature of Resistance and Support
The Channeling Trading Range
Reaction High and Low Prices
The Bouncing Price within a Trend
The Flip
Wedge-Shaped Trends
Triangle-Shaped Trends
Support and Resistance Zones
Breakouts as Signals of Supply and Demand Adjustment

Chapter 4: Trendlines and Channel Lines: The Shape of Thin

gs to Come
Signal Patterns versus Trends
Trendlines and What They Reveal
Price Increments on Charts
Trend Angles
Internal Trendlines
Validation of the Trend
Retracement versus Reversal
Fibonacci Retracement
Channel Line Types
Expanding with the t-line

Chapter 5: Reversal Patterns: End of the Trend

The Dilemma: Minor or Major Reversal
Reversal versus Consolidation
The Time Element: Momentum of Reversal
 Reversal in Western Patterns
Head and Shoulders
Gaps
Rounding Top and Bottom
Rectangle Top and Bottom
Double Top and Bottom
Diamond Formations
Reversal in Eastern Patterns
Long Candles
Doji Formations
Hammer and Hanging Man
Engulfing Pattern
Harami and Harami Cross
Doji Star
Piercing and Meeting Lines
Three White Soldiers and Three Black Crows
Morning and Evening Star
Abandoned Baby
Squeeze Alert
Divergence and its Role in Reversal Trends
Breakouts and Proximity to Resistance or Support
Conclusion

Chapter 6: Continuation Patterns: A Bend in the Trend

Continuation and its Relationship to Reversal
Western Continuation Signals
Head and Shoulders
Inverse Head and Shoulders
Gaps
Rounding Top and Bottom
Rectangle Top and Bottom
Double Top and Bottom
 Diamond Formation
Flags and Pennants
Cup and Handle
Eastern Continuation Signals
Long Candlesticks
Long-Legged Doji and Spinning Top
Thrusting and Separating Lines
Side-by-Side Lines
Tasuki Gap
Gap Filled

Chapter 7: Confirmation Signals: Turning the Odds in Your F

avor
The Causes of Price Movement
Behavioral Psychology and the Market
The Flaw of Overconfidence
Resistance and Support as Keys to Confirmation Proximity
Strong and Weak Confirmation
Momentum and Timing of Preceding Trends
Divergence Analysis and Confirmation
Fundamental Analysis and Confirmation
Confirmation Bias

Chapter 8: Consolidation Patterns; The Sideways Pause

Consolidation and its Meaning
Resistance and Support as Keys to Consolidation Reading
The Triangle Breakout
Volume Spikes and Gaps
Breakout Signals
Consolidation Plateaus
The Bollinger Squeeze
Chapter 9: Volume Signals: Tracking Price Trends
How Volume Confirms Trends
Confirmation Trends with Volume
Trends with Volume-Marked Breakouts
Trend Climax and Gap Patterns
On Balance Volume
Accumulation/Distribution
Money Flow Index
Chaikin Money Flow
Chaikin Oscillator

Chapter 10: Mind the Gap: When Price Jumps Signal Change
The Nature of Gaps
Gaps Filled or Unfilled
Gap Up and Gap Down
Common Gaps
Hidden Gaps
Breakaway Gaps
Runaway Gaps
Exhaustion Gaps
Island Cluster
Ex-Dividend Gaps
Gaps as Part of Other Signals
Gap Proximity to Resistance or Support

Chapter 11: Moving Averages: Order in the Change

Two Moving Averages
Bollinger Bands
Convergence
Divergence
Price Crossover
MA Double Crossover
 Resistance and Support

Chapter 12: Momentum Oscillators: Duration and Speed of

a Trend
The Nature of Momentum
Relative Strength Index
Moving Average Convergence Divergence
Stochastic Oscillator

Chapter 13: Volatility: Marking Risk within the Trend

Calculating Volatility
Volatility Indicator
Evolving Volatility Levels
Average True Range
Volatility According to the VIX

Chapter 14: Fundamentals: Connecting the Two Sides

Value Versus Growth
The Concept of Fundamental Volatility
Dividend per Share and Increased Dividends
P/E Ratio
Revenue and Earnings
Debt to Total Capitalization Ratio
Comparing Fundamental Trends to Technical Trends

Chapter 15: Overview: Putting It All Together

Moving from Downtrend to Consolidation
Secondary Trend Volatility
Large Price Move Ending Primary Trend
Primary Trend with Secondary Trend
Consolidation Primary Trend with Failed Breakouts
Conclusion
Bibliography

Index
Introduction to the Second Edition:
The Basic Problem with Numbers
In the first edition of this book, the purpose was to fill in the
many gaps discovered in the literature about stock market
trends.
This book is intended as a serious study of trends for
experienced investors and traders. These individuals know how
trends behave but also need to solidify their analytical tools for
trend analysis. There are no simple answers to predicting trend
direction, strength, or duration. However, specific tools
technicians favor can be used in combination to anticipate
trend reversal or continuation, and to confirm those moves.
Many books have been written on this topic; however, most
are outdated and do not provide readers with a practical view
of how trends work and how they can be studied. The best
known book on the topic was first published in 1948, and in the
new edition, the charts are seventy years out of date and
limited to line charts; there are no candlestick charts in the
book (although, ironically, the cover art shows a representation
of candlestick patterns). One chart compares industrial to
“rails,” an old term for what today is called the “transportation”
average.
The purpose here is not to criticize other published books,
but to point out the lack of practical and actionable information
about trends. No other book truly addresses the methods of
technical analysis needed to properly understand short-term
and long-term trends and how to determine whether they will
continue or reverse. Most books do not address the third type of
trend (beyond bullish and bearish), the sideways-moving trend
or consolidation. Many books refer to this as “continuation,”
which is an error of definition.
These and other issues led to the publication of this book’s
first and updated editions, with added emphasis in the many
areas useful to traders. The trend, after all, is supposed to be
somewhat predictable. Traders employing all the technical tools
can improve timing of entry and exit of their trades and
overcome the elusive and often mysterious unpredictability of
market prices.
Price movement is not as unpredictable as many believe; it
is only a matter of traders’ uncertainty about how to read the
signals and how to move confidence as close as possible to 100
percent so that trades can be timed expertly.
Getting to 100 percent is impossible because even the
strongest signals will fail or mislead at times. The purpose of
trend analysis is not to become perfect in timing the market,
but to improve the percentages of being correct versus being
wrong, or settle for 50/50.
Contrary to the pessimistic conclusions of some market
theories (efficient market hypothesis and random walk
hypothesis), it is possible to predict price movement. One goal
of this book is to convince the reader that it is possible (very
possible) to profit in the market with improved timing. It comes
down to how you define the market.
Many will say the market is efficient or random, or both. Is
this a fair definition of the market? No. Many technical tools
offer powerful predictive qualities and enable you to improve
well above the 50/50 “guess” many claim defines the market.
The claim to efficiency or randomness (usually made by those
who do not trade in the real-world of the market) is
demonstrably false and unsupportable.
Experienced professional traders realize that the market is
neither efficient nor random. Even the Dow theory, the basis of
traditional technical analysis, does not agree on identification
of changes in primary trends. The meaning of trends is debated
endlessly among technicians. Is a change in direction a new
primary trend, a secondary trend, or merely a retracement?
The debate is ceaseless and there appears to be more
disagreement than agreement on the basic question of how
trends behave.
In this uncertain trading environment, how do professional
traders manage effectively? This edition offers methods of trend
analysis based on a few sound principles. These include the
essential observation of the trading range; reversal,
continuation, and consolidation; confirmation methods; gaps;
and non-price signals confirming or forecasting changes in the
current trend.
Every experienced trader who relies on a short list of
reversal and continuation signals, who understands how chart
analysis is performed, and wants to recognize changes in the
price pattern, already understands how uncertain a trend can
be, and how difficult it is to quantify signals in the moment.
Every trader deals with conflicting and contradictory signals,
and may easily overlook the larger picture of movement in the
trend.
These movements may be simplified and classified as
reversal, continuation, or consolidation. However, this
identification is never 100 percent clear or precise. Experienced
traders may not be certain about the current status of
individual stock trends even with an advanced level of
knowledge. And those who do know also understand that the
current status of a trend is likely to change at any moment. A
trend in an individual stock is likely to be easier to track and
predict than a trend in an index. The index contains many
different stocks, so the trend is itself the sum of net increases
and decreases in price levels for all the components.
Furthermore, the index itself, such as the Dow Jones Industrial
Average—the favorite gauge of the market—may be weighted
so that a few stocks account for a large portion of a total trend
movement. This makes trends of indexes less certain. Even
though many stocks track the market closely, this book focuses
on individual stock trends. In these cases, it is more reliable to
associate trend activity with both fundamental and technical
causes and responses.
The many charts representing price patterns and trends are
based primarily on the period between 2012 and 2016. During
this period, the market did not trend strongly so that the stock
charts were easy to track. Between 2016 and 2018, however, the
overall market moved into a strong bullish trend. The Dow
Jones Industrial Average moved 7,000 points in less than two
years following the 2016 election. Because so many stocks
followed this trend, most charts were bullish. This meant that
demonstrating trend characteristics was less varied than during
more typical, slower-trending markets. As a result, the charts in
this book are outdated on purpose, but the visual summaries
they provide are relevant to trend analysis. Using historical
rather than current charts also adds the clarity of hindsight,
enabling an analyst to better understand what went on and
how trends and prices behaved during a past period.
The first chapter reviews the basic theories about trends and
examines whether or not those theories offer reliable
intelligence traders can use to time entry or exit. Chapter 2
expands that discussion by introducing statistical observations
traders may use to improve accuracy of both trend analysis and
price pattern analysis. Chapter 3 provides in-depth analysis of
how resistance and support play an essential role in trend
analysis and how these trading range borders may be used to
test the strength of the trend. Chapter 4 expands on the
discussion with a study of trendlines and channel lines.
Chapters 5 and 6 are exhaustive studies of reversal and
continuation patterns; and Chapter 7 provides the same in-
depth analysis of confirmation. In Chapter 8, the nature of
consolidation is examined in its effect on trends. Chapter 9
takes a look at volume. In Chapter 10, gaps describe how trend
movement can be anticipated in the near future and how these
may be either revealing or confusing. Chapter 11 examines the
role of moving averages and how these impact and anticipate
changes in trends. In Chapter 12, momentum oscillators are
examined in how they affect not only price, but the larger
trends as well. Chapter 13 addresses the topic of volatility in the
trend and Chapter 14 shows how fundamental trends
contribute to technical trends. Wrapping up the entire
discussion, Chapter 15 puts together multiple indicators to track
how trends continue and change over time.
A distinction has to be made throughout this book between
price patterns and trend attributes. The study of price charts is
normally focused on very short-term trends and likely reversal
or continuation. This is based primarily on patterns found in
candlestick charts or in the application of well-known technical
signals. The key here is that price analysis is short term.
However, beyond those day-to-day and week-to-week analyses
and swing trading decisions, the longer-term trend may be
revealing in many more ways than the price trend could
possibly provide. For example, in a short-term price trend,
assumed levels of resistance and support and, most notably,
violations above resistance or below support, often are used as
the basis for timing of trades. And in fact, movement through
these all-important price levels is invariably the point where
reversal or continuation signals have the greatest meaning.
However, there is a problem in basing decisions on resistance
and support that are short term in nature.
These levels may exist momentarily, but the bigger picture is
found in how resistance and support provide structure for a
longer-term trend. In terms of technical trading, this can mean
a matter of months rather than of days or weeks. However, the
identification of resistance and support (as well as other trend
attributes) only becomes reliable when the charter looks at this
bigger picture. So a few standards are applied in this book with
these concerns in mind. First, analysis of trends is focused on
individual stocks and not as much on index or market-wide
movement. Second, trends are studied as longer term (three
months or more), a departure from the swing trading approach
based on price patterns and identification of reversal signals as
a primary signal. The degree to which reversal and
continuation signals are analyzed is based not on the
immediate price pattern but on how the trend behaves over
time. The concept here is that traders expect short-term price
movement to be chaotic and fast, but longer-term trends often
are far more reliable in terms of where prices are heading. This
is reflected in the trend and articulated by the technical
analyses described in coming chapters.
Even though nothing can ever be 100 percent certain or
clear, the tools presented in this book will help to improve
confidence in timing of trades and also in longer-term decisions
to buy, hold, or sell shares of stock. The quantification of
“confidence” may be described as existing between 50 percent
(random likelihood of a trend moving upward or downward)
and 100 percent (certainty of what will occur next). The study of
a trend will always fall somewhere in between these levels,
never quite falling to completely random 50 percent and never
rising all the way to 100 percent. However, in that range, you
will be able to define confidence in degrees that help manage a
portfolio of equities and to determine levels of risk. For trend
analysis, risk may be defined as a level of confidence in the
current policy. For example, if you hold stock that has
appreciated over several months, where does your confidence
reside today? Is the trend continuing or leveling out? What do
these patterns mean in terms of confidence?
This theory of portfolio management, basing concepts of risk
on levels of confidence in the current trend, may help you to
improve timing not only of entry, but also of exit from a current
position. This may be thought of not as swing trading in the
short term, but of risk management for the long-term portfolio.
It all relies on the trend.
Chapter 1
The Theory of Trends: Dow, EMH, and RMH
in Context
This book is meant to give you a detailed practical
understanding of trend analysis, that part of technical analysis
dedicated to trends and in particular the analysis of individual
stocks. A premise of this book is that the market is neither
efficient nor random and that trades can be reliably timed
based on observation of price behavior within a trend. The
debate as to whether the market is efficient and random, or
neither, is not settled by any means.
Not everyone will agree on the definition of the trend itself.
A trend identifies the direction of movement in an observed
price over time. In terms of stock charts, this usually refers to
price. But the duration is important as well. Every trader must
decide whether to adopt a short-term outlook, such as that of
the day trader and swing trader, relying on fast price changes;
or a long-term outlook based on the study of longer-term
trends. A basic statistical reality is that the longer the period
studied, the more reliable the observation. In other words, you
cannot establish a trend by price action of a few days, but with
price action of a few months the trend and its properties (such
as resistance and support, momentum and volatility) become
clear.

Key Point: A trend is the action of price in a specific direction that

lasts until a change in that direction occurs.
Five Assumptions about Short-Term Trends

You can observe some attributes of short-term trends as the

initial hint of the longer-term trend. Duration of a trend matters
greatly, because a “short-term trend” may, in fact, not be a trend
at all, but a retracement. This occurs when a strong price
movement reverts back toward the previous price level.
1. Price acts and reacts within a larger and longer-term trend.
When you look only at price and attempt to anticipate
which direction it will take next, you must operate on a set
of assumptions. The greatest of these is that price acts and
reacts within the current trend. If you do not recognize or
find a trend, the price is truly random. And some stocks are
both volatile and unclear about direction, which makes any
kind of trade timing both difficult and risky. But that is
often a short-term problem, whereas longer-term trend
analysis is likely to identify clear trends characterized by
short-term chaotic and random movement but overall
identifiable direction.
2. Supply and demand for shares matters. The second
assumption is that price movement reflects supply and
demand within the market. While this is true over the long
term, short-term price movement is likely to be
characterized by reaction to any number of information
pieces, including fact and rumor, fundamental and
technical clues, and investor behavior (which in the short
term is often irrational and crowd-following in nature). For
short-term price analysis, relying on supply and demand
may not be reliable; it is more likely to be chaotic and
irrational in nature.
3. Duration of a trend cannot be known in advance. A third
assumption is that trends tend to continue for some length
of time. However, the actual time involved varies and is not
predictable, so it is ill-advised to attempt to recognize a
trend and settle in on the assumption that time is on the
side of the trend. This is not necessarily the case. Therefore,
trend analysis must include the likelihood that an emerging
signal could foreshadow the end of the trend and a reversal
of price movement; and that this reversal can be caused by
a variety of emerging factors, including supply and demand
but also much more. Whether a change in the trend is
caused by a flip in supply and demand or a less rational
market belief about a company or its stock price, the
change is a reality—no matter what underlying
fundamentals are at play. The technical aspects of the trend
(price patterns, volume, moving averages, and momentum)
are based on a variety of rational and irrational influences.
Therefore, you need tools for trend analysis; if prices were
truly efficient in how they react to fundamental news, the
market would be not only efficient but predictable as well.
In fact, “efficiency” as used in observation of stock prices
refers to the speed of response to information, both true
and false, and not to the efficiency of price as an accurate
measure of value. Markets might be quite efficient in
response time, while making the distinction between
responses to either type of information.
4. Markets do not behave e ciently. A fourth assumption
concerns market behavior. The inefficiency of markets is
easily demonstrated by a study of earnings surprises and
resulting stock price behavior. Stock prices fail to account
for earnings surprises and often overlook the effects of
optimistic beliefs about stocks (especially growth stocks).
 These factors distort and may even lower net returns when
earnings do not perform as expected.1
5. Most traders overreact to any surprises. A fifth assumption,
notably among contrarian investors, is that most market
traders and investors overreact to any surprises or
uncertainties in the market. Therefore, they tend to add
greater meaning to the latest news and to assign lesser
meaning to older (and perhaps more reliable) information.
Contrarians time decisions not merely to contradict what
most market participants are doing but are more likely to
act based on a different set of criteria. Most traders time
and enter both buy and sell trades as a gut reaction to
surprises and in the extreme will trade based on greed
(when prices have risen) or panic (when prices have
fallen). The contrarian, in comparison, tends to enter trades
based on recognition of exaggerated price movement,
especially following earnings surprises. This is done in the
knowledge of a likely correction of that overreaction within
a matter of a few days.

Key Point: Trend behavior reflects market behavior; short-term

price movement often is an overreaction to today’s news.

For example, on January 16, 2015, SunTrust Banks (STI)

reported earnings of $394 million, down from $426 million in
the prior year’s quarter; and earnings fell from 77 cents to 72
cents per share. This negative surprise caused the stock to drop
approximately 5 percent in two days. However, price
rebounded in the immediate sessions following the drop. This is
typical of price behavior and demonstrates the contrarian
advantage. The initial response to a negative earnings surprise
was a substantial drop in price, but that was immediately
corrected. A contrarian acting on knowledge of the behavior
would be likely to take bearish trade action on January 16 and
then close the position to take profits on January 19 or 20 when
price had corrected the overreaction. This price movement is
summarized in Figure 1.1.

Figure 1.1: Reaction to earnings surprises

Source: Chart courtesy of StockCharts.com

The apparent price action is typical of short-term movement

especially in reaction to earnings surprises. A positive surprise
would be expected to behave in the same manner but with
prices moving upward in an overreaction and then correcting
in following sessions.
Testing for this price behavior is difficult for short-term
price action, whereas longer-term trend analysis discloses far
more reliable patterns including reversal or continuation. A
basic error made by many traders is to assign too much value to
the short-term trend, and this begs the question about the value
of studying longer-term trends. The assumption many traders
hold is that of price correlation, the belief that today’s price
trends correlate with or mirror previous price changes. This is
not the case. The price correlation assumption has served as the
basis for criticism of technical analysis in support of a random
theory about the markets. However, it is applicable as a
criticism only to the degree that traders act on the assumption
of price correlation. An enlightened trader or investor,
especially a contrarian, rejects this assumption and
acknowledges that a current price pattern and activity within
an existing trend is separate and apart from prior price
behavior.

Key Point: Price correlation—a belief in the connection between

price moves and previous price changes—is misleading and is
not a reliable basis for trend analysis.

The Beginnings of Trend Analysis: The Dow Theory

The science of trend analysis began with Charles Dow. A

reporter, he gained attention when he published a series of
articles in The Providence Journal. He moved to New York and
established Dow Jones & Company with his partner, Edward
Jones. In 1883, they published their first daily paper, the
Customer’s Afternoon Letter. Six years later, this two-page
newsletter was expanded and renamed the Wall Street Journal.
The extraordinary thing about Dow was his observation that
financial information about a company could be tracked and
trends developed to quantify financial values. This was the
study of fundamental information, a company’s revenues and
earnings over time. Dow did not imagine his trend analysis
skills applying to stock prices, as his interest was on the
fundamentals only. This was decades in advance of the SEC
requirement for public companies to publish audited quarterly
and annual statements. Dow’s emphasis was on pointing out the
truth about financial trends, especially for companies that
manipulated reported profits and losses. This was occurring in
an era before regulation, when corporate reporting was often
highly unreliable and even deceptive. Dow’s publications
included quarterly and annual information about many
publicly traded companies.

Key Point: Charles Dow developed the trend to track financial

information. His theory was later applied to stock price behavior
and today is the basis for trend analysis; it has been named the
Dow theory.

Dow also devised the first stock averages. The first such index
consisted of nine railroads, a shipping line, and Western Union,
as well as a handful of other traded companies. Railroads were
emphasized because they were the most actively traded types of
companies at the time. Dow passed away in 1902, well before
the concept of tracking averages and the Dow theory itself were
formalized. Eventually, the first set of averages evolved and
formed the basis for how market wide trends are followed and
how reversal is signaled. However, Dow himself saw the study
of averages as useful in observing business trends but not for
tracking stock prices and trends. The Dow theory as it is known
today was developed over many years by Dow’s successor as
editor of the Wall Street Journal, William P. Hamilton.
A problem with any type of collective analysis, including the
thirty stocks in the Dow Jones Industrial Average (DJIA) is that
movement in the index represents the net of all movements of
the components, both up and down. Although the DJIA is the
most popular version of what investors consider “the market,”
it does not represent the tendencies or trends of any individual
stocks. It may, in fact, cloak what truly is occurring in many
stocks outside of the selected components of the DJIA or any
other average. Another flaw is found in the weighting of the
DJIA, resulting in heavy influence of a few companies. For
example, as of September 12, 2018, five stocks accounted for
one-third of the total weight of the DJIA:

Boeing 9.2%
UnitedHealth 6.9%
Goldman Sachs 6.0%
Apple 5.8%
Home Depot 5.5 %
Total 33.4%2

This may be troubling to many investors and traders. These five

companies represent one-third of “the market” based on their
weight on the DJIA. A price-weighted index like the DJIA starts
out by adding together the price of the components and
dividing it by the number of stocks. However, any time a stock
splits, the divisor is adjusted. The net result of this is that
higher-priced stocks end up having more impact on the overall
index weight. Therefore, five stocks account for one-third of the
index value. This is a troubling reality. It means that “The Dow”
does not represent what is happening in the market but only
what is happening among thirty big companies. It’s true that
stock values tend to follow the DJIA, but when you consider
how these stocks are weighted, it is deceptive at best. In this
respect, the wishful thinking behind the tracking of such an
average is a type of “cloud cuckoo land” for investors.3

Key Point: The method of weighting indexes like the DJIA means
that “the market” is influenced by only a handful of companies.
This may easily distort how DJIA movement affects an individual
stock’s performance.

In addition to the DJIA, three other indexes are used by the

market, and this is an essential element of the Dow theory. They
are the Dow Jones Transportation Average (DJTA), consisting of
twenty transportation companies (airlines, trucking companies,
shipping, and railroads); the Dow Jones Utility Average (DJUA),
including fifteen utility companies; and the Dow Jones
Composite Average (DJCA), an index of all sixty-five stocks in
the other three indexes.
The Dow theory is designed to track the overall market trend
and not individual stocks. However, many of the principles
about confirmation in the Dow theory apply equally to trend
analysis of individual stocks. This discipline establishes rules of
trend analysis and is what gives the Dow theory prominence
and value among traders. It is not so much the movement of the
average that matters but application of the rules establishing
and defining trends in general.

The Dow theory forms the core of trend analysis of stocks. The
theory includes six basic tenets:
1. The market contains three movements. These are the primary
(major) trends that lasts from under one year up to several
years, and may be either bullish or bearish; the medium
(secondary reaction) trend, lasting from two weeks to as
long as three months, and assumed to retrace from 33
 percent to 66 percent of primary movement since the
beginning of the primary trend; and the minor (swing)
trend, lasting from only a few hours up to a month or more.
These three trends tend to coexist. For example, a
medium trend plays out within the longer-term primary
trend; and the swing trend serves as an adjustment to the
medium trend.

Key Point: Trends make sense when the three specific types are
acknowledged. Even so, it is impossible to forecast how long a
trend of any duration will continue.

2. Market trends go through three distinct phases. For bull

markets, these are the accumulation phase, characterized by
the purchase of shares among knowledgeable investors; the
public participation phase, in which a broader cross-section
of the market recognizes the popularity of a company and
buys shares of its stock; and a distribution, or selling phase.
During the middle phase of public participation, another
phenomenon occurs. Speculation levels increase as traders
buy shares in the belief that prices are going to continue
rising into the future. As this occurs, knowledgeable
investors (who began buying when no one else was) now
begin selling against the speculative fever. The phases of
market trends reveal why the contrarian approach make
sense. Most market participants (the “crowd”) invariably
miss the changes in trends and tend to buy and to sell at the
worst times.
For bear markets, three phases also occur but in a
different sequence. First is a distribution phase, in which
knowledgeable investors begin disposing of shares that have
 appreciated to the point of being overbought. The middle
phase is a bearish version of public participation in which
the market at large recognizes that the trend has turned.
Selling activity spreads as the bear market expands and this
phase may also be characterized as a panic phase. Most
investors want to get out of long positions before prices drop
further. The third phase continues the selling activity in a
widespread segment of the market and a slowing down of
price declines. During this time, a gradual return to
accumulation of shares occurs among knowledgeable
investors who recognize that prices have declined to bargain
levels. The overall decline is likely to slow and even to move
into a sideways consolidation phase.
The three phases do not apply in the third type of trend, a
sideways movement known as consolidation. This period
can last several months or even years, during which prices
are in a range bound by a narrow breadth of trading. The
lack of identifiable phases does not make consolidation any
less of a trend than bull or bear markets; it is, however,
more difficult to interpret.

Key Point: The three distinct phases of every market define

investor behavior and enable investors to track a trend’s
development over time.

3. The market discounts news and this is reflected in prices. One

efficiency of the market is that all news is absorbed and
reflected in stock prices immediately. However, this does not
confirm the efficient market hypothesis (EMH)that states
that reaction to news is always efficient. The fact that all
news is discounted immediately does not make a distinction
 between true and false news. It also does not mean that
price reaction is reasonable. Some forms of news (such as
earnings surprises) cause an immediate overreaction in
price, which is then adjusted (later during the same session
or in one to two sessions that follow).
This belief cannot be proven beyond doubt. However, it is
a worthwhile part of the theory behind trend behavior. It
explains retracement or sudden turns in trends, whether the
theoretical and underlying reasons for these movements are
caused by news or by other factors. It also does not explain
why prices change based on rumors that have not been
confirmed. In practice, this discounting of news (broadly
speaking) may act in an inefficient manner. This better
explains actual price movement in the short term, which
tends to be highly chaotic.

Key Point: Even though markets are efficient in the immediate

discounting of price for known information, it does not make a
distinction between fact and rumor.

4. Averages must confirm one another before a change in the

trend is acknowledged. This is a simple idea. For a trend to be
acknowledged as new and opposite of the previous trend, it
must be witnessed in the major average (the DJIA) and
confirmed in one of the others (the most popular being the
Transportation Average). However, in practice, analysts do
not always agree about whether confirmation has occurred
when a turn in direction occurs. Some will believe it is
confirmation, but others will deny this and call it a
retracement or a secondary trend.
 The reliance on the transportation sector made sense at
the end of the nineteenth century. At that time the United
States was a leading industrial and manufacturing country
and factories depended on railroads to ship their products to
the market. Dow’s original belief was that activity among
railroads reflected the state of the economy. This was true in
1900 and it remains true today. Even with a decline in
manufacturing activity in recent years, the United States
remains a dominant manufacturing force in the world,
second only to China.4
Charles Dow believed that a bull market could occur only
if both industrials and railroads rallied together, and that by
the same argument a bear market was not valid until a
decline in the industrials was confirmed by a decline in the
rails. Even with today’s global markets, this logic may still
apply and it explains why the same requirement for
confirmation is used. Even though transportation now
includes not only rails but trucking, shipping, and air freight
companies, the connection between industrial profits and
transportation activity is direct.

Key Point: Confirmation is a key element of all changes to an

existing trend. No reversal can be accepted without strong
confirmation.

5. Trend status is confirmed by volume of trading. Another form

of confirmation is found in volume. The shares traded and,
more specifically, changes in that number (either a higher or
lower number of shares traded) tends to confirm a change in
the mood of the market and thus in the trend as well. A
smaller level of volume is not as significant as a larger
 volume, especially when that volume spikes much higher
than a typical level of trading activity. This indicates greater
interest in that stock, whether among buyers or sellers.
Dow speculated that high volume represented the true
sentiment of the market, driven by one side or the other;
and that increased volume signaled the direction to follow in
the trend as well. As a form of confirmation, under this
theory, a sudden increase in volume may signal the end of a
current trend and beginning of a new one. When this logic is
applied to individual stocks, it clearly confirms other
reversal signals. The application of the idea to marketwide
averages like the DJIA is not as certain. However, as a tenet
of the Dow theory, the role of volume has led to recognition
among traders that volume indicators should not be ignored
in the analysis of trends and reversals.

Key Point: Volume is directly related to price and often

anticipates coming changes in the current trend.

6. Trends continue until specific signals show that they have

ended. The final tenet of the Dow theory is logical. A trend
remains in effect until reversal signals and confirmation
reveal that the trend has ended and reversed. This applies to
averages as well as to individual stocks.
This rule about trends is profound for many analysts.
Trends do not suddenly end for no reason or without signals
announcing their end. Those who subscribe to the random
walk hypothesis (RWH) would disagree, claiming that all
price movement is entirely random and movement in either
direction is 50/50. However, if that were true, it would be
impossible to spot specific trends and unlikely that price
 movement would be able to continue in one direction for
any duration. A 50/50 random chance occurrence would
dictate that prices would rise and fall in either direction
about half the time. The existence of very real trends
disproves this idea. Dow was correct: trends continue if no
signal arises to point to reversal and confirmation of the end
of the trend.

Key Point: Trends continue until reversal signals are located.

Trends never simply end for no observable reasons.

The Dow Theory Applied

The tenets of the Dow theory can be observed in the study of

price charts, more in hindsight than in foresight. Now of
analysis, it is more difficult to interpret the meaning of a
reversal in price. It might be a retracement or a secondary
trend or it might be the beginning of a new major trend.
As applied to individual stocks, all the Dow tenets serve as
important features of charts and the discipline of technical
analysis. To study the Dow theory in practice, a review of price
charts for the industrials and transportations is instructive.
Even with the imperfections of price-weighted averages like the
DJIA, the tenets of this theory provide a foundation for analysis
of trends in individual stocks.
The biggest decline in the DJIA in history occurred between
October 2007 and March 2009, when the index lost 54 percent
of its value. From a high of 14,164.53, the DJIA ended at 6,542.05
on March 9, 2009.5
After that big bear market, the DJIA bounced back to its
previous five-digit levels. Tracking this history, the DJIA chart in
Figure 1.2 reveals the long-term trend in effect for three years.
In the first two years, a long-term primary bullish trend was in
effect. A secondary trend moved the index lower, only to then
resume the major trend. Later, the market resumed and
continued this long-term bullish trend. The year 2016 ended
below 20,000. By September 2018 the average had moved up to
over 26,000 but at year end was at 23,387.

Figure 1.2: Dow Industrials—2009 to 2016

Source: Chart courtesy of StockCharts.com

Key Point: A review of historical price behavior reveals the

predictability of price within clear trend movements.
Under the most often watched tenet of the Dow, confirmation
by a second average, the Dow Transportation Average tracked
the industrials with remarkable consistency. Not only did the
Transportations follow the DJIA down from 2007 to 2009, it also
confirmed the return to a bull market between 2009 and 2011
and from 2012 through 2016. This is shown for the same period
in Figure 1.3.

Figure 1.3: Dow Transportation—2009 to 2016

Source: Chart courtesy of StockCharts.com
The long-term established rising line of resistance was similar
for both averages and support, also rising, marked the major
trend. The most significant feature of this confirming chart
occurred in mid-2011, when a secondary trend in the DJIA took
the index down 2,000 points over a three-month period. Was
this a valid trend? With confirmation by the Transportation
Average, it was clear that the direction had changed.
Even so, the question remained: Was this a new primary
bearish trend or only a secondary trend? The answer was
revealed in the last three months of 2011 when the DJIA turned
once again and rose sharply and this turn was mirrored by the
Transportation Average. Similar patterns and confirmation
followed between 2012 and 2016.
The comparison makes the point that when direction of a
primary trend changes and is confirmed, the trend itself
(primary or secondary) is real. During this period, an additional
number of swing trends were also seen, which is typical of any
trend over time.

Key Point: The confirmation of DJIA trend reversal is found in

similar changes in a second average, often the Transportation
Average.

Chart interpretations are subjective. Distinguishing between a

secondary trend and a swing trend is a matter of opinion and
difficult even in hindsight. The most difficult part of this
analysis is in reading the meaning of reversals and
confirmation in the moment. Does a strong reversal mean the
trend has ended? Or is it one of many swing trends or a new
secondary trend? Analysts who study the Dow averages rarely
agree universally on what current trends mean. For averages
like these, confirmation beyond a second average is the most
dependable form of confirmation. For individual stocks, many
additional types of confirmation may be applied more
effectively because one stock is tracked more accurately than
an index consisting of many stocks.

Key Point: Is a trend a secondary or a swing trend? Because the

duration overlaps, it often is difficult to know. However, the
important thing is to recognize when reversal has occurred.

The comparison between the Industrial and Transportation

Averages establishes the validity of the concept itself.
Confirmation reliably and consistently reveals the nature of
trend movement.
Beyond the Dow theory, additional ideas about the market
should be discussed as well. Two of these pertain more to price
patterns than to trends, but they define concepts about how the
markets work. These two are the efficient market hypothesis
(EMH) and the random walk hypothesis (RWH).

Other Price Theories: EMH

The markets are sometimes described as informationally

efficient. This means not that price movement is purely
efficient, but that price movement is efficient in the way that it
responds to publicly known information (whether true or not).
The theory goes on to explain that because of this efficiency, it is
not possible to consistently beat the average returns of the
market.
The origin of EMH is traced to 1970 when Professor Eugene
Fama of the University of Chicago Graduate School of Business
(the Booth School) wrote that better than average returns are
not possible based on the analysis of historical price
information.6
The distinction between absolute efficiency and
informationally efficient markets is worth evaluating. If you
assume that “information” includes both true and untrue
forms, earnings surprises, and other announcements that are
not truly influential in valuation of a company’s stock, then it is
likely that market prices react efficiently (immediately).
However, markets cannot be considered efficient in a real sense
because of the obvious overreaction of price to immediate news
(earnings surprises being primary in this observation). Fama
did not agree with this distinction. He wrote that,
In an efficient market, competition among the many intelligent participants lead
to a situation where, at any point in time, actual prices of individual securities
already reflect the effects of information based both on events that have already
occurred and on events which as of now the market expects to take place in the
future.7

This belief is not universally accepted; in fact, many have

challenged it. One study concluded that,
Significant return from technical analysis, even in conjunction with valuation
methods, tends to argue against the efficient market hypothesis. Consequently,
there is a close link between the validity of technical analysis and the inefficiency
of the market.8

There can be no absolute or conclusive belief concerning EMH

because it is a theory. Studies are based on what is observed in
price behavior. However, for anyone following secondary or
primary trends, the concept of efficiency in the market may be
questioned and ample evidence exists that momentum of
trends changes over time and often reversals can be accurately
predicted with the use of strong indicators and confirmation. If
prices relied solely on efficiency in the markets, prices would
reflect information rather than the momentum of trends. These
two attributes—information and momentum—are not likely to
match up consistently.

Key Point: The “efficiency” of markets refers to the speed of

discounting based on known information. It does not mean that
information is reliable or even true.

Unlike information such as earnings surprises or merger

announcements, trends are statistically likely to become
established with a duration, level of momentum, and slope of
change within the chart and to continue until that momentum
changes and the trend slows down, pauses, or reverses. Thus,
information tends to occur without any reliable or predictable
schedule, whereas the shape and duration of trends tends to act
within the boundaries of what can be observed statistically.
Among the statistical tendencies of trends are frequently
observed characteristics. These include price patterns of a
specific nature that anticipate reversal or continuation of swing
trends and secondary trends; the proximity between discovered
signals and the price points of resistance or support; and the
strength of signals and confirmation. These characteristics
relate to price patterns within swing trends but may also be
observed in secondary and primary trends.

Types of EMH in Theory

Studies of the efficient market theory have led to a breakdown

into three distinct types: weak, semi-strong, and strong. The
weak form observes that prices reflect all publicly known
information from the past. In the semi-strong version, the belief
is expanded to include both past and current information and,
further, that traded security prices change instantly so that the
current price always reflects all known information. The strong
form of EMH expands to the belief that prices also reflect
insider information not known to the investing public.
These distinctions all raise a key question about the
efficiency of the market. Does it include any distinction between
reliable or true information, versus rumors that may end up
being unfounded? Does “efficiency” mean that reaction to
earnings surprises is also rational or normal? This must be
questioned because it often occurs that an earnings surprise
causes considerable price movement beyond what would
appear rational and that price tends to retrace and self-correct
within a short period of time. This often occurs within the same
trading day as the day when earnings were announced, or
within two to five days after.
These price gyrations are far from efficient. In fact, they are
both inefficient and irrational, which are the true
characteristics of the market. A trader must expect to see this
short-term chaotic price behavior, while also knowing that
exaggerated price volatility tends to self-correct quickly. A
logical conclusion is that while the market reacts efficiently to
information, price movement is not always rational and does
not always reflect an accurate reaction. The price reaction may
be efficient in the sense that it occurs quickly, but it is not
efficient in terms of the degree of movement based on the
relevant information.
The word “efficient” is inaccurate because of this. A more
accurate world would be “responsive,” meaning that prices
respond immediately, even when the overreaction so often seen
will retrace back toward a more normal (or, efficient?) level of
price change.
 One alternative way to address this issue is to speculate
about whether the markets act or react efficiently. Anyone who
has seen the price reaction to earnings surprises knows that the
immediate reaction to the surprise is very likely to be an
overreaction, to be followed quickly by a correction to that
overreaction. So even if markets are efficient in the reaction to
information, they are not able to distinguish between true and
false information, and the reaction itself is by no means
efficient.

Key Point: It is possible, even predictable, that price will react

efficiently, even when the level of reaction is inefficient. This
leads to immediate correction of overreactions, especially to
earnings surprises.

For trend analysis, this distinction is a key one. Anyone relying

on the behavior of the trend will notice the statistical tendency
of trends over the long term to behave in a mathematically
predictable manner, moving with a specific momentum and
stopping or reversing only when that momentum changes. This
is predictable and rational behavior. However, the efficiency of
reaction to information may not always lead to an efficient or
rational price movement in the short term. For this reason,
reliance on technical signals and confirmation popularly
applied to price patterns and swing trends also can be applied
to longer-term trends with equal reliability. The problem with
EMH is that it does not indicate “efficiency” at all in the price of
a stock, but rather describes efficiency in the speed of
discounting information into the price.
Another way to describe the problem with EMH is to analyze
its message in relation to market behavior. EMH requires that
investors and traders act with rational expectations, an
economics hypothesis stating that predictions and expectations
are equal to the expected value derived statistically.9
This efficiency standard assumes that investors tend, as a
group, to behave rationally and to apply logical standards based
on relevant information and to update their predictions based
on newly-revised information. This obviously inaccurate
assumption recognizes the tendency among individuals to
overreact or underreact to specific information while believing
that the market will behave efficiently.
The assumption about overall markets acting efficiently does
not match with the observed technical science of trend patterns
and observations. Even on the basis on averages like the DJIA,
the confirmation from a second average like the Transportation
Average is remarkably consistent and demonstrates the
strength of confirmation even among dissimilar organizations.
Even with the flaws of weighted averages, the primary trend
confirmation challenges EMH. Even the extreme primary
trends like the bear market from 2007 to early 2009 that took
the DJIA down 53 percent cannot be deemed as efficient. The
fundamental attributes of the thirty DJIA stocks did not
rationally justify a 53 percent drop in overall index value; even
so, the index dropped despite the known fundamentals of the
companies that made up that index.

The Bubble Effect

The EMH concept is comforting in a sense. It explains how

markets are supposed to work and adds an element of
consistency and predictability to the markets, even though
markets do not act in accordance with those ideas.
 Markets are more likely to go through price bubbles, and
over time numerous bubbles have appeared and even more
readily disappeared. Bubbles are followed by sudden and
violent adjustments like Black Monday in 1987 and the demise
of the dot.com sector following its bubble. During bubbles, “the
market” may experience times of irrational exuberance, a term
first used by Chairman of the Federal Reserve Alan Greenspan.1
0

Key Point: A “bubble effect” demonstrates that long-term trends

are subject to short-term distortions. These tend to self-correct
quickly.

The extreme market movements between 2007 and 2009 have

drawn EMH into criticism. Following the 2009 decline, several
published criticisms of EMH made the point that efficiency is
not necessarily at play, especially during a period when
primary trends are strong and long-lasting. It may also be the
case that a reduced level of accuracy in financial disclosures
reduces the efficiency of markets, rather than conforming to it.1
1

This criticism of EMH points to the flaw based on wording.

Investors and traders who subscribe to EMH often do not
understand the distinction between informational efficiency
and accuracy. They take “efficiency” to mean that markets are
accurate, and as prices move in response to information they
tend to behave inaccurately and to correct (and at times, to
overcorrect). None of this short-term price behavior is efficient.
The problem within the market is the mistaken belief that
efficiency is the same as rationality or accuracy.
 The many market periods of either irrational exuberance
(bull markets) or irrational dread and panic (bear markets)
highlight a point about EMH. It might be true that markets are
“informally efficient” in the sense that reaction to news is
immediate. However, efficiency cannot be isolated to reaction
time when, in fact, the level and scope of reaction is itself
inefficient. A huge market rise or fall invariably exceeds any
fundamental reasons underlying a price move in any form of
trend, but especially in a primary trend. The largest bear trend
in history, from 2007 to 2009 with its 53 percent drop in Dow
index valuation is not supported by the fundamentals of the
thirty stocks in that average. Neither is the bounce from 2009
through 2012 supported in any specific fundamental
improvements among the thirty Dow stocks.
Implications of calling the markets “efficient” include the
assumption that reaction to news also leads to efficient and
rational price movement. History has shown repeatedly that
markets overreact to both good and bad news, to true and false
news, and to events and news that have nothing whatsoever to
do with fundamental value. If the market is informally efficient,
it does not reflect good judgment among investors in the ways
they respond to information. In the short term, markets are
chaotic and inefficient, and even EMH proponents concede this
point. However, the more disturbing reality is that longer-term
trends also are inefficient in the way changes in price levels
occur, both for index tracking and for individual stocks. At least
for individual stocks an intermediate self-correcting effect
grows from supply and demand. When stocks are overpriced,
selling dominates and when they are underpriced, buyers take
over. This has the effect of maintaining an economic balance
within individual stock prices, a form of true efficiency based
on supply and demand and not on information.
Key Point: A consistent “cause and effect” in price reaction and
overreaction is characteristic of the immediate character of
supply and demand in any market.

What is the confidence level that a stock’s current price is the

“right” price? That is what matters. Cybercurrency is an
interesting example. Is the current price representative of a
poor risk, or is it priced at bargain levels? For any issue—
whether cybercurrency or listed stock—supply and demand
does cause price movement, but the right price is all in the eye
of the beholder.
Adding to the long-term inefficiency of “the market” as
measured by the DJIA, is the fact that the Dow Jones Company
replaces components periodically. What is the rationale for
this? Some companies become obsolete and should be replaced,
and that makes sense. However, in some cases the reasons for
removing some companies and placing others in the list of
thirty is not as clear. Since its inception in 1884, the Average has
been changed fifty-four times. For example, in 2013, four new
companies were added to the DJIA: J.P. Morgan, Nike, United
Technologies, and Visa. Dropped were Alcoa, Bank of America,
Hewlett-Packard, and Merck. In March 2015, Apple (AAPL) was
added, replacing AT&T (T). In 2018, one of the original Dow
components, General Electric (GE), was replaced by Walgreen
Boots (WBA). Without doubt, the periodic replacement of stocks
on the DJIA influences its climb in index level.12

Other Price Theories: RWH

Closely associated with EMH is the random walk hypothesis

(RWH). In this concept of the market, all changes in stock prices
are entirely random and cannot be forecast with any reliability.
If the EMH rationale is accepted, current prices reflect all
known information. Thus, any further movement in price is
subject to evolving information, but the direction of movement
is entirely random.
However, if the market is truly random, no trends could
possibly develop. Prices would tend to move in a completely
50/50 manner, moving upward half of the time and downward
the other half. The examination of any stock chart over time
reveals that this does not occur. Trends for indexes as well as
for individual stocks develop, move, and continue moving until
reversal signals appear. At this point, the price might level out
for a period of consolidation and indecision and then either
reverse or continue in the previously established direction. A
truly random outcome, such as the outcome of the spin of a
roulette wheel, would be black nearly half of the time and red
nearly half of the time. Zero and double zero move the odds
slightly in favor of the house so that red or black occurs in 47.37
percent of spins. With a total of thirty-eight possible numbers
included one through thirty-six plus zero and double zero, the
random odds are:

18 ÷ 38 = 47. 37%

The RWH premise was analyzed by professors of finance at the

MIT Sloan School of Management and the University of
Pennsylvania. Their conclusion was that RWH is wrong and
that trends do exist, making the markets predictable, at least to
some degree.13
Key Point: If markets were truly random, no form of analysis
would have value. The theory of a random market has been
questioned many times and the conclusion is that markets are
by no means random.

Supporters of RWH point to the equilibrium of supply and

demand as explanation for this random assumption about stock
prices. However, this would require that buyers and sellers
come to the table at the same time and that no news affecting
price occurs at that moment. RWH always requires efficiency in
the price as well as an equal number of buyers and sellers who
agree about the fairness of the current stock price. Neither of
these are likely to occur consistently enough to support RWH as
a reasonable theory about markets.
The fact that buyers and sellers are rarely available in equal
numbers is one of the factors creating trends, even ignoring
fundamental realities of the company. The vacuum assumed by
RWH is that markets work with extreme efficiency and balance,
but this ignores the reality in another very important manner.
The fundamentals of companies reveal that over time, some
companies grow in terms of net profits and market share; they
increase dividends they pay; they acquire or merge with
competitors; and they invent new products and processes.
Other companies lose market share and profits as their
products become obsolete and as competitors outperform them.
Some companies mismanage their costs, such as General
Motors, whose debt/equity ratio rose above 200 percent before
bankruptcy was inevitable. This meant that debt accounted for
more than the total valuation of the company and that equity
was nonexistent. Since GM has reformed and continues to take
part in the market, the underlying problems were fundamental
and far from random. The success or failure of a company (and
as a result, the rise or fall of its stock price) is inevitably traced
to tangible and precise underlying fundamentals and not to
random luck. Companies like General Motors, Eastman Kodak,
and others failed because of fundamental causes such as
obsolescence, failure to compete, lack of control over costs, and
other problems; and successes like Amazon, Walmart,
Microsoft, and McDonald’s also are not random but the result of
keen competition, product exceptionalism, and smart
management. None of these are random influences on the
fundamentals, and they also explain why the stocks of
successful companies experience long-term bullish trends.

Key Point: Stock prices of well-managed companies tend to

move in a bullish trend over time.

The equilibrium of supply and demand based on the

assumption of an equal number of agreeable buyers and sellers
is unrealistic. RWH relies on this assumption, but the truth is
that supply and demand is rarely in equilibrium. It changes
based on competitive pricing and quality. There is nothing
random about strong competition, excellent management, and
quality of products or services. Within a single day or week, a
stock’s price moves in a chaotic and possibly random manner
and a reason to study trends. The momentary struggle between
buyers and sellers reflects ever-changing adjustments to supply
and demand, but the larger picture and the longer-term trend
clarify what really causes prices to move upward or downward
over time. The numerous short-term effects on stock prices
(profit-taking, bargain hunting, earnings surprises, rumors, or
merger talks, to name a few) create a random effect on stock
prices, but these reflect the short-term, or swing trends only
and not the secondary or primary trends that define a stock’s
price over months or even years. Those longer-term trends
grow from the tangible cause and effect (supply and demand)
based on fundamental analysis. In this respect, the
fundamentals (competition, profit and loss, cash flow) directly
affect the long-term technical aspects (price and movement of
price trends). None of this is random. The nature of price trends
is best described as the technical reaction to the underlying
fundamentals of the company.
Stock prices are unpredictable in the short term, primarily
because next year’s fundamentals are not yet known. It is
unrealistic for stock prices to move randomly without any
cause because trends are easily observed in prices. RWH claims
that it is impossible to consistently beat the market averages;
but with sound stock selection based on the fundamental
record, the long-term technical side consistently yields results.
One aspect of RWH is a belief that technicians, who rely on
analysis of price charts, respond to market and investor
behavior. Under this belief fundamentals do not matter because
investors set the market mood by buying or selling, resulting in
bullish or bearish sentiment. This ignores the glaring
differences between well-managed and poorly-managed
companies in the same sector and the resulting changes in stock
prices over the long term. Investors are far from arbitrary in
how they develop sentiment. As a group, investors favor
profitable companies and do not favor those companies losing
market share and reporting net losses.

Trend Analysis as a Risk Management Process

The explanation of price movement as either efficient or
random ignores the most important attribute of the trend: its
role as a means of risk management.
By tracking stock trends and defining the differences
between swing, secondary, and primary trends, investors
develop methods for managing risk. This is accomplished
through carefully timed trades based on trend behavior. Even
conservative buy-and-hold traders whose portfolio is treated as
permanent, can utilize trends to time defensive measures to
avoid losses. These include closing long equity positions in
anticipation of bearish turns in current trends; the purchase of
put options to insure paper profits; variations of dollar cost
averaging to exploit price movements interpreted as secondary
trends or retracements; and trades undertaken following
exaggerated reactions to events like earnings surprises.

Key Point: In a very real sense, trend analysis is a method for

risk management. By recognizing trends as they evolve,
investors and portfolio managers can better time entry and exit
decisions.

By taking steps such as these, all investors provide risk

management attributes to trend following. Understanding how
trends work and recognizing or forecasting upcoming reversals
is interesting by itself but becomes meaningful when the
knowledge is applied to reduce and eliminate risk.
Among the risk-reducing methods investors employ is
articulation of risk itself through formulations like risk-adjusted
value. The expected cash flow from an investment (whether
dividend yield, option premium, or capital gains) expresses
expectations of net return from an investment. The
probabilities assigned to expected cash flow define how this
calculation ends up. For example, an investor purchases shares
of stock based on several fundamental attributes, including an
attractive dividend yield. What is the probability of the
dividend continuing to be paid and what payout ratio will apply
each year? A set of assumptions like this identifies risk once
future cash flow is discounted and based on a range of
probabilities.
When calculations such as risk-adjusted value are examined
considering historical price trends and forecast into the future,
risk itself can be defined within a range of possible outcomes.
This relies on the continuation or end of a known trend. If this
calculation is performed based on past trends, the variables of
outcome can be assigned varying levels of confidence based on
the strength and consistency of fundamentals. For those relying
solely on technical indicators, risk depends on recognition of
reversal signals. This means not only identifying the likely
reversal of price toward the end of a trend, but also accounting
for the unexpected reaction of the trendline to surprises in
news yet to be announced. A vulnerable set of technical
assumptions may lead to a greater than expected price
adjustment, for example.
This observation emphasizes why the combination of
fundamental and technical analysis improves the
understanding of price trends. The technical side does not occur
in isolation; it is a mistake for chartists to ignore fundamental
analysis in the belief that the fundamentals have no direct or
immediate effect on the movement of price.
The proponents of EMH and RWH base part of their theories
on the belief that technicians rely, often too heavily, on past
price performance and ignore fundamentals in the absolute
trust of price patterns and reversal signals. For investors and
traders intent on using technical analysis wisely, the
fundamentals should not be ignored, but used together with
technical indicators. It makes sense to first select companies as
investment candidates based on the strength of historical
financial results and to then analyze trends over both short-
term and long-term timeframes. This addresses the criticism
offered by proponents of EMH and RWH that technical traders
fit only one mode of behavior.
Trends further help investors to manage risk through
avoidance or transfer. Risk avoidance is the initial result of
thorough fundamental analysis. Investing only in high-quality,
well-managed, strongly-capitalized corporations with strong
competitive position avoids much of the risk (both fundamental
and technical) associated with weaker, poorly capitalized
corporations that also tend to exhibit greater price volatility.

Key Point: Risk transfer combines analysis in both fundamental

and technical trends. This aids in identifying companies with
strong fundamental attributes and price potential.

Risk transfer (also known as risk hedging) is a method of

reducing risk through the purchase of insurance (long puts to
insure equity profits, for example) or application of more
advanced options strategies designed to cap losses often in
exchange for also placing a ceiling on potential profits.
Diversification is another method of risk transfer in which a
range of dissimilar risks are retained in the belief that through
diversification or asset allocation the exposure to market risk is
minimized. When these steps are organized within a program
of price trend analysis, the effectiveness of risk transfer is
heightened and the retained risks are lowered, even with a
spreading of risks through a program of diversification or asset
allocation. The trend is the monitoring tool that alerts a
portfolio manager or investor when positions are moving
toward overbought or oversold conditions.
If portfolio management is aimed at quantifying profits
through trend analysis (which includes anticipation,
recognition, and avoidance of risk), it also becomes necessary to
understand the potential for portfolio losses. Within the science
of trend analysis, the most basic concept for this involves
recognition of how trends evolve and change over time. Is the
pattern volatile or predictable? Is the trend changing quickly or
slowly, flattening out, or retracing frequently? Are specific
reversal signals beginning to appear in the form of momentum
or volume indicators?
All these changes identify the potential for losses to occur if
no action is taken. The potential action may involve closing of
portfolio holdings, buying insurance or hedge derivatives, or
retaining the risk with an awareness of how the risk might be
evolving along with the evolution of the trend. To identify
potential risk of loss in a portfolio, trends are tracked and
analyzed and confidence levels are assigned. If your confidence
level is high that the portfolio is safe in its status from market
risk and other forms of risk, then the trend is a source for that
high confidence. If confidence declines due to changes in long-
term indicators accompanying the price movement, then it
makes sense to adopt a policy for action when confidence
declines to a predetermined level.
One method for assigning a confidence level to portfolio risk
exposure is Value at Risk (VaR). Based on a series of
assumptions concerning likelihood of loss, time, and confidence
interval, VaR may be identified and tracked as a form of trend.
However, rather than resulting from the movement of price
and other factors, VaR is an articulation of risk based on
assumptions.

Key Point: VaR is one of several risk analysis tools. It is the study
of risk levels based on a set of reasonable assumptions.

This process may be applied to a portfolio in general, or to a

security within the portfolio. It is a means for assigning
probability of loss as a percentage. For example, if confidence is
at 90 percent then the potential for loss is at 10 percent. That
loss will be defined in terms of dollar value and period. With
these assumed variables in place VaR can be tracked over time,
and as status changes the holder of that portfolio or stock may
decide when or if to act to protect against loss. The most
reliable means for changing these assumptions are: in the
tracking of intermediate and long-term trends; in recognition of
changes in breadth of trading or volatility; recognizing the
frequency and severity of retracement; and spotting
movements breaking out above resistance or below support.
These analytical tools are part of trend analysis, and by
quantifying risk with the addition of VaR the decision to act
defensively may also be expressed in tangible terms. A portfolio
manager may devise VaR based on several methods. The
historical method includes observation of past trends such as
duration, speed, and degree of reversal when those trends
ended, with one of two approaches: The parametric approach
tracks volatility of a portfolio against an imposed set of
assumptions about net returns. The nonparametric approach is
based on historical trend movement without imposing
assumptions.
 Besides historical methods for developing VaR, the analysis
may be performed solely based on historical volatility or, for
derivatives, implied volatility analysis. For stock trends, this
should include analysis of the breadth of trading and especially
changes in that breadth, attempts at breakouts above resistance
or below support, or changes in volatility within the established
trading range.
All forms of trend analysis may include studies of statistical
moves and probabilities to quantify risk. Or they may be
limited to a combination of technical observations based on
initial fundamental criteria. For example, a first step in
constructing a portfolio and making changes to it may be based
on identifying a set of fundamental attributes and trends over
time (ten years of revenue and net profit growth, for example).
In fundamental analysis, the trend is strictly financial and adds
great value to the identification of strong portfolio candidates.
The next step is to track the intermediate and long-term trends
of a stock, with special attention paid to visual and
mathematical trend monitoring methods. The visual methods
include trendline and channel line tracking, which while
limited in value provide clear views of how trends behave. This
is true in terms of duration and breadth of the trend as well as
clear identification of changes. Mathematical trend monitoring
includes volume and moving average and momentum tests that
are calculated and then expressed in terms of index values
(most notably, flagging areas when a security is overbought or
oversold).

Key Point: Trend analysis combines visual observation of price

patterns with calculated momentum, volume, and price
movement over time. Combining sources strengthens the overall
process of trend analysis.

For most investors, the combined fundamental and technical

approach makes the most sense. Both forms of analysis are
based on trends, one involving financial results and the other
limited to price and volume. Fundamental trends identify the
strength or weakness of the financial results as well as levels of
fundamental volatility. Technical trends identify price behavior
over both short-term and long-term spans and aid in
anticipating even subtle changes in the future, such as a
slowing down in the rate of a trend.
Several statistical tendencies of trends help to further
understand how trends behave and how to recognize changes
in their behavior. This is the topic for the next chapter.

Endnotes
1 Lakonishok, Josef, Andrei Shleifer, and Robert Vishny. “Contrarian Investment,
Extrapolation, and Risk.” Journal of Finance 49 (1994): 1541–78.
2 Dow Jones & Company. September 12, 2019, at http://indexarb.com/indexComponen
tWtsDJ.html
3 Aristophanes. The Clouds, 423 B.C. The reference is to the perfect city erected in the
clouds and named Cloud Cuckoo Land, the ideal and perfect city devised by
characters Mr. Trusting and Mr. Hopeful.
4 United Nations, Industrial Development Organization. World Manufacturing
Production, 2nd quarter 2018. https://www.unido.org/sites/default/files/files/2018-09/
World_manufacturing_production_2018_q2.pdf
5 Planes, Alex. “Why the Dow Hit Rock Bottom 4 Years Ago.” The Motley Fool at www.f
ool.com (March 8, 2013).
6 Fama, Eugene. “Efficient Capital Markets: A Review of Theory and Empirical Work.”
Journal of Finance 25 (1970): 383–417.
7 Fama, Eugene. “Random Walks in Stock Market Prices.” Financial Analysts Journal,
January–February (1995): 75–80.
8 Caginalp, G., and D. Balenovich. “A Theoretical Foundation for Technical Analysis.”
Journal of Technical Analysis 59, no. 5–22, Winter-Spring (2003), http://papers.ssrn.co
m/sol3/papers.cfm?abstract_id=658165.
9 Muth, John F. “Rational Expectations and the Theory of Price Movements.”
Econometrica 29, no. 3 (1961): 315–35.
10 Greenspan, Alan. “The Challenge of Central Banking in a Democratic Society”
(speech presented on December 5, 1996 at the Annual Dinner and Francis Boyer
Lecture of The American Enterprise Institute for Public Policy Research, Washington,
D.C.).
11 Nocera, Joe. “Poking Holes in a Theory of Markets,” New York Times, June 5, 2009.
12 Indexology, at https://us.spindices.com/indexology/djia-and-sp-500/the-changing-dji
a
13 Lo, Andrew W., and Archie C. Mackinlay. A Non-Random Walk Down Wall Street,
Fifth Edition. Princeton, NJ: Princeton University Press, 2002.
Chapter 2
Statistically Speaking: Trends by the
Numbers
Trend analysis is based on technical attributes of price
movement but it can be much more, adding to the value of
signals and price attributes. This chapter examines and
explains the attributes of trend analysis based on probabilities
and statistics.

Some primary points in this analysis are:

1. Statistically, no trend continues forever, but some technical
traders forget to look for signs of plateau or slowdown in
the trend.
2. While a price moves higher, traders need to also track other
indicators to determine when stocks are getting too
expensive based on price earnings ratio (P/E) among other
signals. In this regard, the trend works as an aspect of
valuation, which is easily overlooked if a trader’s focus is
only on the price of stock.
3. While a price lowers, there is a finite level to the trend;
informed investors recognize the point where a stock
becomes a bargain and will move in to buy. At this point,
the less aware investor is still trend-following and is not
looking for the level where the trend is becoming excessive.
4. The trend operates in one of two ways: either it resides
within the trading range and may be expected to “bounce”
off resistance and support, recognized by strong reversal
 and confirmation signals or it breaks out and sets up a new
higher or lower trading range, meaning the trend moves
beyond the previously established range.

Key Point: Every trend shares specific attributes relating to

duration, over- and underpricing of shares, and action of price
relative to resistance and support.

Some traders, even those highly skilled at technical analysis,

may easily overlook the attributes of a trend relative to
underlying statistical tendencies, valuation, and price
movement. The shortcomings of trend-following lead to risk
that might be invisible, especially if the trader is overly focused
on the technical price movement alone without understanding
the trend itself. Trends operate within the valuation of a stock,
and focusing on pattern recognition without understanding
how trends are evolving is an error.
This ability to understand the relationship between price
behavior and the trend has a profound implication: price
movement is not the same as trend movement. A price moves
without specific patterns of reversal, continuation, retracement,
and sideways uncertainty. This all may occur within a larger
primary trend for the stock. Although these shorter-term price
patterns are referred to by chartists as “trends,” they generally
are swing trends but rarely secondary or primary trends. This
is profound because managing the risks of the swing trend is a
short-term process. Many of the well-known reversal and
continuation signals used by swing traders are applicable to
longer-term trends as well, but a technical reaction to these
signals may not look as significant as it is not a small trading
window.
Fat Tails and Trends

Statisticians take comfort in a normal distribution, the well-

known bell curve that illustrates how outcomes are likely to fall
(see Figure 2.1). As the curve moves upward, a greater number
of occurrences are found; as the curve moves to the extremes,
the number of occurrences decline.

Figure 2.1: Normal distribution on the bell curve

Source: Prepared by the author

However, the ideal statistical outcome is a model only. Stock

trends are not normally distributed and, in fact, may appear
random at first glance. There is order and predictability to the
trend, but the trend itself can not be measured in the same way
as other things, such as mortality, physical characteristics, or
auto accidents. In all of these events, a known and likely range
of possibilities exists. These are known as discrete random
variables because they contain a finite number of possible
results. In stock trends, uncertainty about the range itself
means that no plotting of standard deviation is possible.
Outcomes may appear at many points in the bell curve and not
in the classic clustering nearer to the top of that curve. Stock
trends are examples of continuous random variables in which
an unknown range of possible outcomes are in play.

Key Point: Stock trends are not normally distributed because the
variables are changing constantly. Every change in price creates
a new, continuous random variable.

Statisticians identify a given range of possible outcomes,

recognizing that a continuous random variable (like the closing
price of stock in any one session) must fall within that range.
For a stock price, the range is anywhere between zero and an
unknown high, which in theory is infinity. However, on a
practical level, it is reasonable to set an estimate of a likely high
end to the range. Thus, a $20 stock might be assumed to
experience an upward move to $200 per share, but the same
assumption might reject the possibility of price exceeding $200.
Of course, the price could move in the same direction
indefinitely, in theory at least; but as a method for making risk
management as realistic as possible, this limitation makes
sense. It ignores the theory of potential infinite movement and
attempts to add a finite property to the likely range of
movement.
It makes no sense to try and estimate the likely exact value
at any given date, but it is possible to estimate a range of
possible outcomes. In trend analysis, for example, you may
estimate that the current trend and breadth of trading has some
assumed value of (a) continuing to move in the same direction
and (b) maintain the same breadth as it exhibits currently. This
is where the use of specific statistical calculations aid in
articulating levels of risk. Statistical calculation works to define
not only the orderly progress of a trend but also to identify
when it is beginning to change its characteristics.
The probability density functions, or finite possible
outcomes given a set of reasonable assumptions, limit the
estimated range of outcomes. This means that from a statistical
point of view, estimating the direction, duration, and slope of a
trend can be reduced to a reasonable and likely range of
outcomes. Even so, the range will remain broad even when
expressed within a series of continuous random variables. It is
far more instructive in trend analysis to develop methods to
track price and trend development with a system allowing you
to spot potential changes to the trend. You can limit the
“universe” of likely outcomes without being able to identify a
finite range. For example, a stock trading currently at $80 per
share might range in the following year between $40 and $160.
Moving outside of that range is less likely, and the farther out,
the less likely it becomes. This is where another statistical tool,
standard deviation, enters the science of trend analysis.

Key Point: The possible outcomes of a trend can be limited to a

likely range even with continuous random variables. This range
changes, though, with every new price change.

Calculating a likely outcome based on standard deviation

produces a model that also serves as a starting point for
tracking stock prices. To bring order to the tracking of trends,
the application of standard deviation reveals that trends tend to
display fat tails. Rather than a large number of outcomes (such
as a day’s ending price) falling within a standard deviation of
the mean, a high number of a trend’s outcome fall outside of
normal distribution. Some are higher than the expected normal
distribution and others are lower.

Although fat tails “should” be statistically rare, they have been

observed to occur frequently in the market:
Even ignoring Black Monday, if returns were “normal,” statisticians would expect
the S&P 500 to move up or down by 3.5% or more only once every 10,000 years. . .
. In contrast, we’ve experienced 118 such occurrences since 1950—nearly half of
them in the past two years. Over the past two years, the average daily move up or
down has been 1.3%. With that as a baseline, a normal distribution would see a
fat-tailed move of 6.4% once every 100 years. In fact, it has already happened 11
times in the past two years.1

A purist who relies on statistical discipline might argue that this

proves the randomness of a stock trend. However, that is not
the case. It only points to the need for development of statistical
tools to track trends that prove continuation or point to reversal
(or retracement). Using standard deviation helps to set a
standard for trend analysis over the long term. However, even
statistical certainties may not apply to trend analysis in an
absolute sense.

To calculate standard deviation, the following steps are

required:2
1. Calculate a moving average for a set period of time (twenty
days, for example, the period normally used to map
Bollinger Bands, which are based on standard deviation).
2. Find the deviation for each session in the period analyzed.
This is the difference between each session’s closing price
and the average price for the entire period.
3. Square each session’s deviation, the sum of the values
calculated in step 2, or X2.
 4. Add together the squared values for all the periods.
5. Divide the sum of the squared valued by the number of
periods in the analysis. For example, if twenty sessions are
studied, divide by 20.
6. Calculate the square root of the result, which is the
standard deviation.

Analysts relying on free charting services (in this book, StockCh

arts.com is used) can calculate specific indicators based on the
use of standard deviation. So, this set of calculations does not
have to be performed repeatedly. However, it is instructive to
understand how those indicators are developed. Many
indicators rely on manipulation of moving averages to estimate
changes in volume or momentum, and these are examined in
later chapters. Bollinger Bands are one example of an indicator
that overcomes the lack of standard deviation in trends.

Key Point: Standard deviation sets up likely ranges of outcomes

in the current trend. This adds a form of reliability to how
reversals can be spotted and forecast before they occur.

Bollinger Bands

Named for their developer John Bollinger, Bollinger Bands are a

statistically-based system for tracking trends. Specifically, they
track moving averages and the degree to which price deviates
from those averages.3
Bollinger Bands have three moving averages. The middle
band is a simple moving average of price. The upper band is
two standard deviations higher than the price average and the
lower band is two standard deviations below the price average.
All three bands are calculated on the same period, usually
twenty days.
Since the popular bell curve is applicable for normal
distributions, the use of standard deviation in a series of bands
is applicable for stock prices, which do not exhibit a normal
distribution but contain variables and fat tails that can not be
calculated using the pure statistical methods based on finite
outcomes. (How many registered voters will vote? What
distribution of weight ranges applies to fifteen-year-old boys or
girls? Which products do consumers prefer out of three
possible purchases?)
Bollinger Bands are popularly used by chartists as one of
dozens of price indicators. For short-term application, these
traders look for changes in the bands themselves to generate
trades or to find confirmation of a likely reversal and then enter
a trade. This short-term application is effective assuming that
confirmation is also found. However, this may be viewed as an
indicator-specific identification of changing price patterns.
Bollinger Bands can also be applied to secondary and primary
trends as a means for setting up possible changes, including
reversal or continuation. Much of this relies on confirmation in
the form of other indicators as well as analysis of Bollinger
Bands behavior if and when the upper band moves price
through resistance or when the lower band moves price
through support. For analysis of the long-term trend, the
reliability and strength of Bollinger Bands provides an excellent
analytical tool of breadth of trading, resistance or support
strength or weakness, and continuing strength or gradually
evolving weakness in the trend’s slope and duration.
Key Point: Bollinger Bands provide a visual summary of likely
trend behavior. In this sense, the indicator is a form of
“probability matrix” for a dynamic field of prices.

In the short term, Bollinger Bands measure and identify

volatility or market risk associated with the specific stock. This
is of great interest to swing traders, but for those focused on
longer-term trend analysis, the short-term volatility of price is
part of a price pattern expected to exist within the context of a
longer-term primary trend or an offsetting secondary trend.
For both utilizations of Bollinger Bands (swing trading based
on price patterns or trend analysis based on behavior of
primary and secondary trends, retracements, or exhaustion
points seen in the trend), specific action points are identified in
a number of ways. Remembering that the upper and lower
bands are the product of standard deviation, their movement
contains characteristics more meaningful than one-line moving
averages or price pattern signals.
A typical Bollinger Bands analysis added to a price chart is
shown in Figure 2.2.

Figure 2.2: Bollinger Bands

Source: Chart courtesy of StockCharts.com
As the chart for Caterpillar reveals, Bollinger Bands closely
track the movement of price. For the purpose of identifying
turning points in the trend, several predictive elements
appeared during the sideways movement of 2013. The price
approached and touched both upper and lower bands
repeatedly between late April and December. In December, the
price moved above the upper band during most of the month,
an initial indication that bullish momentum was underway.
This should be confirmed by additional signals, but based solely
on what this revealed, the six-month bullish trend through June
2014 was not surprising. During that bullish move, the breadth
of trading was above the middle band and close to the upper
band for most of the period. This added to the strength of the
bullish trend.
In late July 2014, an initial indication of a bearish move—
either retracement or secondary trend—appeared with two
instances of downside gaps. This predicted a strong downside
trend that did not materialize until September and October. At
that point, the price was close to the lower band. The volatility
during the final six months could have been difficult to
interpret without the addition of Bollinger Bands.

Key Point: Indicators like Bollinger Bands aid in interpreting

price trends even when volatility levels are high.

Numerous signals can be taken from Bollinger Bands beyond

just tracking a trend. Actual reversal is also signaled with a
variation of well-known technical indicators similar to the well-
known double tops or bottoms, gaps or head and shoulders
patterns. A variation of this is seen in two Bollinger Bands
formations called the W bottom and M top. On the lower side of
a trading range a W bottom occurs when two reaction lows
occur during a downtrend. This takes place in four steps. First,
price declines to and touches the lower band. Second, price next
moves up toward the middle band. Third, price once again
moves down to a new low price while remaining above the
lower band. Fourth, price responds to the exhibited weakness
of the downtrend and moves strongly higher, potentially to a
break above resistance and the upper band. The W bottom is a
variety of the widely recognized double bottom, and is a bullish
signal.
For example, a typical W bottom is shown in Figure 2.3.

Figure 2.3: Bollinger Bands, the W bottom

Source: Chart courtesy of StockCharts.com

On this chart, two distinct W bottoms appear. The first closely

conforms to the requirements of the W bottom concerning
price and the lower band. It comes close to actually touching it.
And on the bounce, the price moves to the middle. However, the
strongest element is found in the single upper shadow moving
above the upper band at the beginning of November.
The second W bottom follows the bullish rally from
February through June 2014. As price begins falling, it actually
moves below the lower band briefly but strongly. The middle
bounce exaggerates the movement, going close to the upper
band. The second decline (forming a double bottom) also moves
below the lower band.
Both of these W bottom cases can also be analyzed in
connection with support. If support was established in June
2013, at approximately $58.50 per share, the subsequent
declines demonstrate how Bollinger Bands interact with other
technical indicators. The period between August 2013 and
February 2014 moved price several points below support, but
the 2014 rally moved price back into range. The second attempt
at a bearish move was more typical of a double bottom attempt,
with price declining to the established support level twice
before rebounding. So in this chart, Bollinger Bands and the W
bottom also confirmed the strength of support.

Key Point: The W bottom is a variation of the better known

double bottom in technical analysis. The M top is a version of the
double top.

On the higher side of a trading range, an M top occurs when

two reaction highs occur during an uptrend. This takes place in
four steps. First, price rises to and touches the upper band.
Second, price moves down toward the middle band. Third, price
once again moves up to a new high price while remaining
below the upper band. Fourth, price responds to the exhibited
weakness of the uptrend and moves strongly lower, potentially
to a break below support and the lower band. The M top is a
variety of the widely recognized double top pattern, and is a
bearish reversal signal.
 For example, an M top pattern with Bollinger Bands is
exhibited in Figure 2.4.

Figure 2.4: Bollinger Bands, the M top

Source: Chart courtesy of StockCharts.com

The M top formation on this chart is volatile compared to the

previous W bottom. However, it also confirms the activity
expected with a double top. Following both occurrences of the
M top, price levels declined. The chart has many examples of
price moving outside of the upper and lower bands, exhibiting
higher than average volatility for the company. Any type of
double top, whether the well-known signal by itself, or found
within an M top, may be thought of as a lesson that after two
tries at breaking higher, the likelihood is that price will next
continue downward.
This has importance in terms of how stable a trend is and
what you might expect to occur next. The progress of a trend is
likely to include numerous instances of price touching upper or
lower bands, or both. These moments by themselves are not
signals of changes in the trend. However, when a touch of price
to bands forms up as part of larger signal, such as W or M
patterns, it is more significant. Even greater in meaning is when
movements of price are above the upper band or below the
lower band. Price moving above the two standard deviations of
the upper band, or below the two standard deviations of the
lower band, will not remain there for long. The extreme move
outside of two standard deviations invariably leads to price
retracement within the bounds of the upper and lower bands.
A reasonable expectation is that as trends progress, as much
as 85 percent to 90 percent of all price movement should be
contained within the range from upper to lower bands. If and
when movements outside the band begin to occur, it signals
increases in volatility and may forecast a reversal not only of a
swing trade but also of a secondary or primary trend.4

Key Point: With the expectation that a high degree of price

movement is going to remain within the range of Bollinger
Bands, movements above or below are signals of a coming
reversal.

Bollinger Bands present a visual summary of how price

interacts with its well-developed moving average (expressed
within two standard deviations). This is one indicator that
allows you to manage what statisticians refer to as multiple
random events. With stock prices, a number of these variables
are at play with one another, including earnings reports,
market perceptions of growth (and the resulting supply and
demand for shares), and price patterns relative to the trading
range itself. The fact that everyone dealing in stocks goes by
these rules make it a self-fulfilling prophesy. Traders bail out or
jump in when prices move outside of the bands’ zones, and this
applies to all stocks.
 The use of these bands to track averages of price sets up a
simplified but revealing probability matrix in which the
likelihood of a change in the trend can be spotted. As the bands
widen or narrow, the action of price in the middle range,
notably as it approaches, touches, or moves through either the
upper or lower band, may be found not only at times of high
price volatility but at times when a reversal is likely. At times,
however, price moves outside of the band zones, often because
of rumors floating in the market or in anticipation of earnings
surprises, but quickly return to lower volatility and trading
closer to the middle band (the average).
Such a reversal may be relevant only to the swing trend,
either as a short-term reversal or shorter-term retracement. It
may also be more than a reversal of these momentary prices as
reflected in the changes to price patterns, meaning that a
reversal can signal the beginning of a new trend. To confirm
this, additional signals should be found. Common among these
are volume spikes, large price gaps, and strong candlestick
signals. It will also be found as an initial or confirming signal
when a primary or secondary trend is nearing a reversal point.
So, when price moves through upper or lower bands, it sets up
a form of conditional probability. An analyst following a trend
may observe that this volatility implies that a reversal is
coming; but confirmation is also required before assuming that
a signal of reversal is valid. In price and moving averages
analysis this probability is expressed as the “probability of
trend reversal” versus the “probability of price reversal” given
the observed violation of resistance or support, momentum
oscillators confirm a likely reversal, and other forms of
confirmation for both price patterns and the larger trend. The
differences between price and trend reversals must be
remembered.
 A momentum oscillator often will be used to observe price
volatility, regardless of the strength or weakness of the trend.
The oscillator measures the speed and strength of price
movement, but does not test or quantify the direction of
movement.

Statistical Tendencies

The rationale for tracking price trends statistically through

moving averages is to manage the volatility seen in short-term
prices. For many, the price patterns and their highly chaotic and
unpredictable nature explain why so many people subscribe to
the random walk hypothesis (RWH). However, there are
important differences. A truly random price pattern should
consist of no discernible pattern at all or of a non-repetitive
pattern developed coincidentally. This does not occur. Many
patterns occur frequently and some do lead to reversal a
majority of the time. Many of these like the W and M patterns
observed in Bollinger Bands are highly predictive and work as a
method for quantifying variables to a likely range. In this range,
analysts can take the risk of assigning high confidence to the
correlated pattern and its proximity to resistance or support.

Key Point: Proximity of reversals to resistance and support are

crucial. This is the point where reversal is most likely to occur.

When the same observed pattern recognition is applied to

secondary and primary trends, the same rules can be applied.
Just as short-term chaos is managed through price patterns and
confirmation, long-term trends are just as likely to act
predictably given a set of conditional probabilities that are
realistic. For example, combining price trend analysis with
other technical signals such as P/E, revenue and earnings
trends, and other fundamentals change are then searched for in
the price patterns with a trend. When you spot broadening or
narrowing breadth of trading, violations of resistance or
support, and statistically calculated overbought or oversold
conditions, it often points to the trend slowing down and
reversing.
The tendencies of price patterns apply equally to the
tendencies of trends. No trend continues forever in the same
direction, with the same slope and strength, or within the same
breadth of trading. These tendencies are observed statistically
through Bollinger Bands, momentum oscillators, and volume
indicators and subject to confirmation, they are the tools for
predicting and confirming the end of trends, just as they apply
to predict the end of swing trends and the emergence of a new
trend moving in the opposite direction.

Trends and Averages

Stock trends can not be analyzed like most populations in

statistical analysis. When analysis is applied to a well-known
and finite population, sample data are then identified and
isolated for analysis. In a properly selected set of data, the
outcome is expected to reflect behavior of the larger
population.
What is the equivalent in stock price trends? Many would
think that the overall market is the population and index-based
averages are the sample data. This may be true for marketwide
analysis, even with the imperfections of a weighted index. How
is this applied to individual stocks? In the case of stock price
trends, “population” means every possible price down to the
penny above and below the current level of price. This is an
infinite population. So to make the statistical process work, a
sample is much smaller. It consists of likely price movement in
a range of outcomes with further removal of each and every
specific price and preference for a range. This sample is further
reduced by removing unlikely outcomes. For example, if one
stock has trended between $20 and $35 per share over ten
years and currently is at $30 per share, what is a reasonable
assumption about price levels? The range might be limited to
between tangible book value per share on the low end and $50
per share on the high end to be analyzed over a one-year
period. Based on the history of a 15-point range over ten years,
this seems to be a reasonable range of sample data. The limits
to assumptions narrowing down the sample are statistically
referred to as a set of expectations. These exist within the
defined finite variations of possible outcomes, and outcomes
above or below that field are not considered.
Expectations are developed with averages and, especially in
stock trends where values are constantly evolving, the use of
moving averages. The random assumption about the market
states that there is a 50 percent chance of only one of two
events, higher prices or lower prices. This ignores the more
interesting question of how far price might move in one of
those directions. Moving beyond the rather simple random
assumption, trends are identified and used to create that finite
data set that applies assumptions to possible movement
between a “worst case” decline and “best case” appreciation of
price, not infinitely but in a realistic and finite world of
possibilities. This becomes the data set against which a trend
can be tracked.
Key Point: For investors interested in how trends move, the
duration question often is far more interesting than price
direction, which is going to move higher, lower, or sideways.
Duration is much less tangible.

This data set is then exposed to a set of variables. These include

a selected list of fundamental indicators as well as technical
properties (including price, volume, and momentum) and then
tracked within a trend over the following year. As long as the
assumptions about the sample and the appropriate selection of
variables are realistic, a starting point is inserted into the
immediate analysis of the trend. The basic questions to keep in
mind concerning this analysis should include:
1. How long will the trend continue?
2. How are changes to the trend recognized and confirmed?
3. Is a change in direction a swing trade, retracement,
secondary trend, or a new primary trend?
4. What processes can be applied to make immediate
distinctions between price patterns (in swing trends or
retracements, for example) and new secondary or primary
trends?

The analysis of the trend is similar to the analysis of price

patterns, with distinct differences as well.

Trends versus Price

Price is a constantly shifting and moving reflection of supply

and demand for shares of stock. The market reacts to a huge
array of information, both true and false, concerning current
and future earnings, competitive stance and changes in
management, mergers and acquisitions (rumored and
completed), regulatory problems, product recalls, and dozens of
other factors.
In comparison, a trend is a reflection of the collective factors
influencing price. The very existence of trends—easily visible
through a glance at long-term stock charts—demonstrates with
profound clarity that there is nothing random about price
movement. In fact, the easily observed reality of trends in many
shapes and duration completely destroys the intangible theory
stating that price movement is random.

Key Point: Recognized trend attributes apply to all durations and

can be observed and predicted with consistency. This
demonstrates that price movement is far from random.

This reality points to the great advantage investors hold. You

can predict the behavior of stock price in both short-term price
patterns and also in longer-term trends. This has long been
recognized by swing traders whose three- to five-day swings are
based on overreaction to immediate news about a company. On
a longer timeframe, the same observation applies equally well
if not better. That longer timeframe builds in a recognizable
shape to the trend providing a large view of where price levels
have been and where they are moving.
As long as focus is on the day-to-day movement of price, the
longer-term trends are most difficult to recognize. In fact, swing
traders have no interest in what a stock’s price is likely to be
next year or next month. They only care about the timing of
current entry and exit.
This system works well for swing traders moving in and out
of positions with high volume. However, for a permanent
portfolio, defined for this purpose as equity positions held
indefinitely, and as long as assumptions causing the position to
be opened continue to apply, the issue is not timing of short-
term entry and exit but identification of changing risks. If last
year’s promising investment has declined in value when the
same criteria are applied today, the portfolio manager will want
to sell the position and replace it with a new equity investment
that contains more acceptable risks and the potential for higher
income (through capital gains and dividends).
This requires focus on the primary and secondary trend.
This does not mean swing trends should be ignored because
they constitute part of changes to the longer-term trends. It
does mean that in tracking the primary and secondary trends
the underlying causes of short-term price patterns and price
movement are not a point of interest. The portfolio manager is
better served by continuously applying profit and risk criteria
to ensure that the equity position remains viable. This is the
primary difference between trend management and price
pattern prediction.

Strength and Weakness of Trends

As the recognition of a shape associated with the trend—

breadth, slope, duration— is important to recognize, it is also
important to recognize the weakness to any trend. A trend,
when viewed as a risk model, offers correlation between
outcomes that may cover a wide area of possibilities. This
makes price trends more difficult than a fixed field of a sample
population. Every time a price changes, the moving average has
to be updated to reflect the change. So, unlike a product sample
in which consumers are offered choices between fixed products
and their differences, prices are by no means fixed. If the taste
of a food product changed every time it was tasted, it would be
impossible to apply the rules of fixed sampling to determine
how consumers will or will not buy.

Key Point: Breadth, slope, and duration are the attributes of

trends. However, the great challenge is that the population
(stock price levels) changes every day.

In estimating the average of a fixed field, the challenge is not

difficult. This is why the expectation of trend analysis has to be
based on evolving and changing information because the trend
is dynamic. It is convenient to blame the problem of prediction
on randomness in price movement or even on efficiency of
information discounting. Neither apply well enough to explain
why observed long-term trends often have an orderly
appearance. It consists of a very consistent trading range, slope
of increase or decrease in breadth, and interruption of a trend
only with the occasional (and equally predictable) retracements
typical of the stock trend.
Even though a long-term primary trend may appear
consistent over time, there continues to be a serious weakness
in trend analysis. You can not know how long it will last. The
random school of thought points to this as proof of randomness,
but actually there are methods for forecasting when trends will
decelerate, stop, and reverse. No two trends last the same
duration, and so this alone mandates that trends have to be
tracked through a modified expectation model. It is based on
moving averages because the sample data and population are
not fixed but change constantly.
 The nature of stock prices makes trend analysis a form of
nonparametric distribution. In parametric distribution,
statisticians are able to apply a normal distribution to identify a
finite set of likely outcomes, or “statistical hypotheses
concerning the behavior of observable random variables.”5 This
means that a sample studied under normal distribution is more
or less fixed and is predictable. Stock prices are neither fixed
nor predictable. They consist of continually evolving prices and
a data set that will not be the same tomorrow as it is today. The
random variables cannot be limited to a finite number.
This weakness in trend analysis is manageable when the
technical rules of price movement are applied over a period of
time. If a fixed portfolio contains a number of equities that have
been selected on the same criteria, they are also likely to
contain the same set of random variables. Thus, you can expect
two different equities to respond to evolving market
information in similar ways. An earnings disappointment will
have a negative effect on price in the short term, which is just
as likely to correct within a few sessions. This means that a
serious study of tendencies within primary and secondary
trends will lead a portfolio manager into an advanced
understanding not only of price behavior within the trend, but
also for the nature of that consistent body of random variables
applicable to all equities in the portfolio.

Pattern Cycles

The predictability of a consistent set of random variables

among holdings in an equity portfolio is going to be accurate
under a set of further assumptions. These include:
 1. The equities selected were all subjected to the same
selection criteria.
2. These selection criteria affect all equity positions in a
similar manner.
3. The initial criteria and effect have not changed since
positions were acquired.

These variables point out that even subtle differences between

equities may lead to inaccuracies in interpreting factors that
influence trends. The use of diversification and asset allocation
build in normal differences among equities in initial selection
criteria, their affect, and consistency over time. This variability
of portfolio holdings also points to the problem of cyclical
patterns affecting long-term portfolio value and response to
market influences on price.
For these reasons, a technical observation of trends relies on
price patterns including double tops and bottoms, breakouts,
large price gaps, and violations of resistance or support. In
other words, portfolio managers have developed a series of
signals they consider to be reliable in predicting how price is
likely to reverse direction. This practice recognizes that the
patterns popular with swing traders also apply to longer-term
trends.

Key Point: Patterns in price behavior are found in trends of all

lengths. This makes trend analysis applicable equally for short-
term traders as well as long-term buy-and-hold investors.

This is the basis for criticism of technical analysis among

proponents of the efficient market hypothesis (EMH) and the
random walk hypothesis (RWH). The criticism is put forth that
technical analysis relies on the assumption that past price
behavior will be repeated in future price behavior, that chartist
techniques attempt to use knowledge of the past behavior of a
price series to predict the probable future behavior of the
series. A statistician would characterize such techniques as
assuming that successive price changes in individual securities
are dependent.6
However, this is not always what swing traders do, nor what
trend analysts rely on for timing of subsequent trades. In
practice, portfolio managers tracking primary and secondary
trades attempt to pinpoint reversal based on the appearance of
familiar reversal signals. The difference, though, is that unlike
the assumed behavior based on past price movement,
technicians and trend analysts are more likely to use known
signals and confirmation to determine when a trend is about to
turn or has already turned.
Tracking specific signals that have historically led to reversal
more often than not is an intelligent approach to the timing of
trades in the short term and also to the timing of a likely trend
reversal. It is not the expectation that past price behavior will
be repeated but the acknowledgment of predictable signals
marking weakened trends that is most useful. These include
three concurrent observations: (1) price patterns, volume
indicators, and momentum oscillators mark likely points when
the trend is going to slow down, stop, or reverse; (2)
confirmation with signals at least as strong as the initial signal;
and (3) proximity to the price level of resistance or support,
which are the most likely times for price patterns and for
trends to actually go through reversal.

Key Point: Every trend study relies on three key elements:

recognizable patterns, confirmation, and proximity.
Market Sentiment Expressed in the Trend

The current sentiment of the market (bullish or bearish) is

evident in the characteristics of every trend. This applies to
markets overall and movement of indexes; it also applies to
individual stocks.
When investors are confident and optimistic about a
company, its stock trend is going to move upward. This is true
even when price movement is not supported by the
fundamentals. For this reason tracking of price-based range
indicators is one form of trend analysis. Is the price justified by
current and potential earnings?
Tracking the P/E provides the answer. When the range is
between 10 and 25, it is a reasonable mid-range level. If P/E
moves above this level, the stock begins to become expensive;
below the mid-range, there is little or no interest in the
company.
P/E is an odd but useful indicator. It is odd because it
compares a technical value (price) to a fundamental value
(earnings). As price is divided by earnings, the resulting
multiplier represents the number of years of earnings in the
current price (based on latest reporting earnings). However,
whereas price is current, earnings are historical. So, the best
way to use P/E is to study its year-to-year range from high to
low over a long term, such as ten years and to then compare the
trend reflected in this range to the current P/E.
For example, a comparative summary for five years range in
P/E for two companies is shown in Figure 2.5.
 Figure 2.5: Annual P/E range
Source: Prepared by author based on CFRA Stock Reports

Target’s range remained narrow in the period selected, within 5

points for the four latest years. It also remained in the mid-
range, which you would expect to see for P/E. However, the
Costco range was much wider, as much as 8 points; and the last
four years’ high were above the 25 level. So even though the
Costco P/E was not extremely out of range in this period, the
stock was more expensive based on P/E than Target was. This is
a good example of how tracking fundamentals over time,
especially on a comparative basis, provides insight into the
strength of a company. In this case, the fundamental (earnings)
showed how the technical side (price) behaved, and the degree
of change over time.

Key Point: P/E ratio should be analyzed in two ways: the range
from high to low and the trend of range over many years.

Another way that market sentiment is reflected in the trend is a

change in volatility. As investors become fearful, a bullish trend
is likely to slow down or reverse. However, uncertainty most
often leads to a sideways movement, a pause in the trend. If the
uncertainty dissipates, the trend is likely to return and if the
uncertainty worsens, the bullish trend could reverse and be
replaced by a bearish trend.
Market sentiment is always present, even when investors
are uncertain. This occurs during a bear trend as well, when
the price decline pauses and begins moving sideways. This
reflects a sentiment of uncertainty about the bearish trend and
may be a precursor to bargain hunting and, eventually, to a
new reversal and bull market in the individual stock.

Momentum Trading

Short-term trading (swing trading) relies on both overreaction

to surprises and to momentum within a short-term trend. Chapt
er 12 examines momentum in the context of longer-term
trends. It is closely associated with short-term buy and sell
activity, often involving only a two- to five-day turnaround.
Momentum often is the impetus for closing trades even if the
original intention was to keep the position open longer.
Momentum is the strength and speed of any movement. In a
football game, an interception gives the team in possession
immediate momentum, and the other team loses momentum. In
stock trading, a strong and swift price movement gains
movement as long as that movement continues in the same
direction. Eventually, momentum declines, seen in a leveling off
of price and one of three following conditions: resumption of
the movement in the same direction, reversal and movement in
the opposite direction, or an indefinite sideways movement
(called consolidation). Momentum is the measurement of
strength and speed of price movement, but it is not concerned
with the direction of price movement.
 Momentum is a popular method for determining whether to
open a position and, once opened, when to close. It is a binary
index, a statistical summary of a moving average equated to an
artificial index. A specific index value marks overbought
conditions and another marks oversold. In a majority of
oscillators, these ranges create a condition in which an orderly
trend will remain in the mid-index of the oscillator. As long as
this remains true, the momentum-based rationale is that the
trend is in effect and is not changing. However, if the
oscillator’s index value moves into the over-bought or oversold
range, momentum traders will close existing positions or
exploit the condition by opening new ones.

Key Point: Momentum is the analysis of the strength and speed

in price movement, but not its direction. As momentum moves
into the overbought or oversold range, it signals likely reversal.

For example, Figure 2.6 includes an example of how a

momentum oscillator (Relative Strength Index or RSI) confirms
a likely reversal occurring at resistance.
 Figure 2.6: Relative Strength Index
Source: Chart courtesy of StockCharts.com

On this chart, several examples of movement in the RSI into

overbought and oversold territory appear. However, they are
for the most part very brief, and the index quickly returns into
mid-range. However, at the beginning of November, price gaps
high and moves through resistance. The potential for a reversal
is always great at such occurrences, but it is made even more
likely by what RSI does. The index moved strongly into
overbought range, not only above 70 but on two occasions
exceeding the 80 index value. Most significant, RSI remained
above the overbought line for six weeks. Looking at the
previous charted period, it is clear that RSI rarely stays out of
the mid-range for long. So this event, coupled with the gap and
high move, indicates a very strong possibility of reversal.
This was a good example of how momentum is used to
confirm the likely reversal in a trend. That may be a new
primary or secondary trend, a retracement, or a swing trade.
Tracking RSI and other momentum oscillators helps to
understand trend behavior over many time periods. For
example, the Visa chart revealed a six-month duration in which
the stock was overbought. Even though momentum is relatively
simple to follow and the “rules” are quite clear, it presents only
one of many trend indicators. No decision should be made
concerning the end of a trend without confirmation, and that
takes many forms. The Dow theory version of confirmation is
the same—reversal between two indexes. For individual stocks,
confirmation will be found in momentum oscillators, volume
indicators, and price pattern signals (both Western and Eastern,
or candlestick-based).

Statistical Measurements and Trend Behavior

Distinguished

Traders generally understand that markets do not always

behave as expected, even when strong indicators are tracked
and monitored. Statistical measurements are attempts at
bringing order and predictability to an otherwise chaotic world.
This is accomplished through identification of likely outcomes
or probabilities and applying statistical measurements to arrive
at a conclusion.

Key Point: Despite a desire to create predictable analysis

through the use of indicators, the great variable remains
unpredictable behavior among investors.

Trend behavior contains so many random variables that the

statistical world is of only limited value. Many tools such as
moving averages, especially those based on comparisons of
ranges to price and standard deviation, are especially useful in
trend analysis. However, with most statistical models, the effort
is based on a study of sample data drawn from a fixed
population. Stock prices and trends are dynamic and the
population itself changes with every trade made in the overall
market.
With the complexity of the statistical challenge in trend
analysis, the limitations to statistics have to be accepted. In fact,
trend behavior, even with a strong data set and statistical
analysis, is not going to behave in conformity with an assumed
range of outcomes. The problems of a large number of variables
make it impossible to accurately and reliably pinpoint the range
of outcomes when it comes to stock trends.
The most likely way to use statistical means for tracking of
trends is with indicators like Bollinger Bands and its three data
sets (average, upper bands, and lower bands). The application
of two standard deviations from the middle band can not
predict where the trend is heading, but it can reveal moments
when the direction of the trend is in jeopardy and when a
reversal has become more likely.

Spikes and How to Manage Them

One principle of statistics is that within a range of values,

notably unusual instances should be removed. These spikes
distort the average, whether simple or exponential. For
example, in a series of stock ending prices within a trend, if the
normal breadth of trading is between $25 and $30 per share, a
one-time spike to $50 should not be considered typical.
To consider something a spike, it should be unusual and it
must not be repeated. It is an aberration in every sense and in
order to maintain accuracy of a statistical analysis, it should not
be included in an analysis of price behavior.
However, a spike in a stock trend also presents potential
problems that should not be ignored. For example, is the spike
truly an aberration or does it forecast volatility in the near
future not otherwise predicted in the breadth of trading in the
current trend? An analysis of the trend has to allow for this
possibility. So on the one hand, statistically a spike is removed
to maintain the order of an otherwise “typical” range of
outcomes. No special significance is assigned to the spike itself.
However, looking at the issue from a different point of view,
does the trend have a meaning outside of the statistical
movement of the trend itself?
Because the population of a range of stock prices is changing
continuously, a spike could have meaning outside the trend,
especially compared to a trend based on a fixed population
with a fixed set of possible variables.

Key Point: Volume spikes often accompany reversal, but in

analysis of trends the spike itself has to be discounted when it
distorts the more typical average.

For example, in tracking a multiyear trend in the P/E ratio,

identifying the trend between high and low, the outcome tends
to remain in a range of 6 to 8 points, between 20 and 26 or 28.
In one year, the P/E spiked to 45 during a period of high
volatility in the stock price. This has two distinct meanings.
First, statistically speaking, the spike would be removed from
the analysis because it was not typical. However, in the year in
question, a rapidly moving price curve making the stock too
expensive would tell an investor to expect a correction. If the
price remained out of range of a reasonable P/E, then it would
also remain overpriced and that is good information for anyone
wishing to avoid the correction that must come eventually. So
the second meaning of a spike is that, even beyond statistical
treatment of non-recurring aberrations, the spike changes the
valuation of the stock. As such, it may be a temporary problem
that self-corrects. However, if it does not self-correct, a portfolio
manager would have to consider taking profits and moving to
the sidelines and wait to see how price acts in the future.
Spikes occur often in volume and signal a likely reversal. So,
if a trend experiences a spike in volume in an otherwise stable
trend, it could be a “power spike,” reflecting the known
relationship between price and volume. A volume power spike
should not be ignored in the context of trend behavior, but it
might be necessary to overlook the statistical implications,
remembering that the price population is not a typical one for
statistical analysis. The power spike could have great
significance and even signal that the trend is about to reverse.
For example, the one-year chart for Amazon.com marked
four distinct volume spikes, each accompanied by clear reversal
signals. This is shown in Figure 2.7.
 Figure 2.7: Volume spikes
Source: Chart courtesy of StockCharts.com

The first of four spikes occurred at the same time as a double

bottom. The resulting reversal was short in duration and was
followed by a six-week bearish move. This concluded with the
second volume spike occurring in a two-day formation, which is
unusual. This also marked the first of three segments in an
inverse head and shoulders, a bullish indicator. This occurred
as price trended below support, strongly hinting at a likely
reversal, which occurred immediately.
The third spike occurred as price peaked and then gapped
lower by 40 points from the mid 360s down to the mid 320s.
After this, price continued to decline until it met established
support. The fourth volume spike occurred as price gapped
below support once again. The combination of the gap,
breakout, and volume spike were a convincing signal and
confirmation.
Amazon.com is a particularly volatile stock; and volatility
also means uncertainty as the gyrations of the one-year chart
exhibit. Investors do not like uncertainty in a permanent
portfolio, and the spike represents uncertainty. For investors,
uncertainty and risk are the same because both draw attention
to concern about what happens next. So, a spike is an
opportunity to manage the trend statistically, but it is also a
signal that risks are greater as long as the volatility remains.
Considering the dynamic nature of trends, the statistical
approach is not as appropriate as a technical view that a spike
could signal a coming change in the trend.

After the Spike: Breakouts and Reversals

In attempting to manage a trend, changes and corrections

should not be ignored. Even so, investors are constantly aware
of retracements and of price behavior at or near resistance and
support. When price moves through one of these, it tends to
reverse and return into range. This reversal is also called a
pullback. The potential for this to occur is the orderly
assumption applied as long as the trend remains in effect.
When a breakout succeeds, a new trading range is set. This
could expand the trend into further territory with increased
speed and for an extended period. The tendency in the market
is to think of this in terms of bullish rallies; however, it also
applies to bear markets on the downside.

Key Point: Successful breakouts lead to bullish reversals when

resistance is violated; the same rule applies to bear market
breakouts below support.

Reversals, whether temporary or permanent, are most likely to

occur close to the edges of the trading range. A breakout
characterized by long days (long between open and close) and
moving up toward resistance or moving down toward support
increases the chances for reversal, especially when that long
day is also a spike. Second, when the breakout is accompanied
by a price gap between sessions, this also increases the
likelihood of reversal. The larger the gap the greater the
likelihood of reversal.
While this observation about breakouts and reversals is
clearly applied in swing trading, it also has application in
longer-term trends. Trend analysis requires constant
monitoring, so investors seek both reversal signals and
confirmation that a trend is ending. Beyond price, volume
indicators and momentum oscillators may be used as
confirmation for the possibility of a trend coming to an end.
However, numerous weaker signals will occur during the trend,
with primary trends offset by secondary ones and secondary
trends offset by swing trends. So the end of the single-stock
trend (like the end of an index trend) is not clear-cut and
demands analysis and study of related signals.

Statistical Analysis of Fundamentals

Trend-following is almost always associated with technical

analysis and, specifically, price patterns. It is used more as a
timing device for swing trading than as a longer-term method
for portfolio management. However, it applies to both varieties
when focused on price.
Beyond the technical trend, the fundamentals are also
tracked over time. This makes sense when following any
number of indicators, although a short list could be limited to
only a few strong signals. Using a five- to ten-year trend ensures
that a picture of fundamental strength or weakness will
emerge. Among the signals that are most useful in fundamental
trend analysis are revenue and earnings (not only the trend of
each but the relationship between the two); dividend yield and
payout ratio; P/E range over a period of time; and debt/equity
ratio, representing the trend in increasing or decreasing long-
term debt as a percentage of capitalization.

Key Point: Most trend analysis is focused only on price and

volume behavior. However, fundamental trends also affect price
movement, although a time delay is also likely.

An example of a fundamental trend was previously shown in

the comparison of P/E high and low ranges for two companies
over five years. The trend is revealing but so is the comparison
between two companies, especially if they are in the same
sector. This type of fundamental trend analysis may serve as a
decision point for a trade decision in the equity portfolio. Once
positions are opened, continuing fundamental trend analysis
reveals whether fundamental criteria are continuing to be met,
or if not, when a particular position should be closed and
replaced with a company with stronger fundamentals.
Trend analysis and its many components are based on
application of statistical principles even with its limitations. The
statistical “rules” as applied to stationery populations bring
order to the analysis of sample data. However, for a dynamic
population such as stock prices within a trend, many of those
statistical rules have to be mitigated through confirmation. This
includes volume spikes confirmed by double bottoms or
inverted head and shoulders, for example, or the application of
W bottom and M top to identify the strength and continuation
(or end) of a trend relative to Bollinger Bands patterns.
Statistical principles are strong tools in trend analysis, but
these become useful in context when viewed as part of a
behavioral study. This is where game theory can help a
portfolio manager to improve the understanding of how
decisions are made.

Game Theory Applied to Trend Analysis

An element of statistics is associated closely with game theory, a

science involving the mathematical and statistical decision-
making process. It is “the study of mathematical models of
conflict and cooperation between intelligent rational decision-
makers.”7 The underlying assumption of game theory is that
decisions are made in an intelligent and rational manner. Part
of the culture of the market is based on the often irrational
behavior of market participants at large versus the minority of
contrarian investors.
Contrarians act as they do not just to go against the majority
but based on analysis and rational conclusions versus the
impulsive and emotional approach used (unconsciously for the
most part) by a majority of traders and investors.
The starting point in appreciating game theory is the zero-
sum game. This is any situation in which the sum of gains on
one side are equal to the sum of losses on the other. Many
participants in the market assume that it is a zero-sum game,
that an individual’s profits are gained at the expense of losses
on the other side. However, this is not the case. Because
growing companies increase their capital through profits,
growing stock prices are generated and not taken from
someone else. The market is not a zero-sum game; however, if it
is treated as if it were, then the resulting decision process will
be flawed.

Key Point: Price movement is not a zero-sum game with set

values exchanged between one group and another. The
expansion of value resulting from profits is more complex.

Application in trend analysis of statistically model game theory

concepts requires several elements. First, there must be players
of the game (investors, who may win or lose). Second, at specific
decision points there must be a payoff (profit or loss). Third,
each player has access to the rules of the game (information, for
example, about specific companies and their stocks) and fourth,
actions have to be available (buy, sell, hold of specific stocks
and selection of stocks based on the information set that is
available).
Some analysts of game theory use a decision tree, a set of
binary actions that determine whether you win or lose. The
decision tree simplifies the “game,” however, because it often is
based on the assumption that players make decisions in precise
steps, and one at a time. In investing, you face a potential range
of decisions concurrently, and actual decisions might not be
made in any particular order. (Buy and then sell is one idea, but
so are incremental trading, short selling, and wait-and-see.)
Game theory is worth studying because it demonstrates how
the human mind approaches problems and arrives at decisions.
By reducing this complexity to mathematical models, the
process and outcomes are more easily understood. An analyst
following a trend is not merely looking for a moment when the
trend will reverse and set up a new trend in the opposite
direction, although that is one result you expect to find in the
trend, or more to the point, to anticipate through recognition of
forecasting signals. When you are able to anticipate what is
likely to occur beforehand, you gain an advantage in the timing
game.
Trend analysts, like players in many games, do not
necessarily make decisions in a sequential manner such as
those on a decision tree. The decision tree works for simple and
binary forms of games like tic-tac-toe, in which a predictable set
of outcomes is known in advance. A properly played game will
always be a tie, meaning that no player with equal knowledge
can gain an advantage over an opponent. Investing is on the far
end of the spectrum from the simplest form of game.
Some games are instructive in demonstrating how difficult it
is to make decisions without full access to all information,
including the thinking process of other players. This is
illustrated in the prisoner’s dilemma. In this game, two
prisoners are captured and are being interviewed by the police.
There is not enough clear evidence to get a conviction without a
confession. So an offer is made to each: betray the other by
testifying against him for a reduced sentence. The possible
outcomes: If both take the deal, each gets a reduced sentence. If
one agrees but the other does not, the latter gets a longer prison
sentence. If both remain silent, they are likely to both go free or
serve a lower sentence on a reduced charge.8
The dilemma for each is lack of knowledge. Is the other one
cooperating? If so, then the smart move is to also cooperate. Is
the other remaining silent? If so, also remaining silent makes
more sense. Applied to trend analysis, you can not possibly
know what other investors are deciding about a company and
its stock, and you also can not know how the stock price will
react to the collective knowledge. You are left with a similar
dilemma. If everyone is going to turn bearish, you should sell
now. But if everyone remains bullish, you should hold or even
buy more shares.
The prisoner’s dilemma demonstrates why “the crowd” of
the market tends to trade based on irrational rather than on
rational motives. Investors are constantly trying to anticipate
the mood of the market and, as a result, investing poorly and
with bad timing. This is why contrarian investing is rational.
Contrarians do not play the prisoner’s dilemma but time their
trades based on observed trend behavior. In other words,
contrarians take a third choice beyond those offered to the two
prisoners. They act independently and refuse to rely on the rest
of the market. Knowing the market is compulsive and
irrational, the contrarian does not fall into the prisoner’s
dilemma because it is not a game that can be won consistently.

Key Point: The prisoner’s dilemma is instructive for stock market

investors. Contrarians are in the minority because they do not
accept the two choices offered to prisoners. Contrarians take a
third choice based on analysis and logic.

Game theory can not provide a guiding force in trend analysis,

but it can help to explain behavior among investors. This is
useful when reduced to statistical and mathematical modeling,
without which trends can not be understood very well. So,
game theory expands the statistical appreciation of the game
itself, without taking over from practical application of statistics
or common sense about the nature of risk. The trend reflects
broad-based attitudes and beliefs, and a contrarian studying a
trend may be likely to spot changes as they begin to occur and
before a trend actually ends and starts moving in the opposite
direction.

Magical Thinking and Trends

The opposite of scientific thought (game theory as one aspect of

statistics) is a far less logical range of ideas collectively referred
to as magical thinking. This describes casual relationships
between events and subsequent responses or actions, which are
not justified in a rational manner. Success due to good luck
tokens, repetitive actions, and compulsive assumptions is
widely believed and practiced, but it is not scientific.
Assumed correlations between ritual and result defy
statistical observation, the application of the scientific
knowledge, inquiry, and objective analysis. Even so, the market
culture is characterized by frequent examples of magical
thinking or, as it is often called, wishful thinking. To many, this
has religious overtones. A worthy person will be rewarded by
profits, whereas an unworthy person (one who sins, is selfish,
or unkind) will have bad outcomes in the market. Even though
magical thinking is irrational, it is often unconscious. Investors
may act on the basis of magical thinking without being aware
that they are doing so. The ultimate in magical thinking is found
in a belief that specific thoughts can and do bring about actual
results: “Thinking that one’s thoughts on their own can bring
about effects in the world or that thinking something amounts
to doing it.”9
So under the doctrine of magical thinking, an individual can
cause a trend to continue or reverse due to their actions, rituals,
or even thoughts. This “associative thinking” confuses an ideal
connection with a real connection. So magical thinking takes on
greater power than analysis and observation, and outcomes are
controllable beyond the hard work of analysis and tracking.10
Magical thinking often occurs when “mental activity is too
little differentiated for it to be possible to consider ideas or
images of objects by themselves apart from the emotions and
passions which evoke those ideas or are evoked by them.”11

Key Point: Magical thinking is a destructive force in trend

analysis. The assumptions of magical thinking are irrational but
are widely accepted in market culture.

Even though this is clearly irrational and clinically associated

with primitive thought, this type of thinking does exist in the
market culture. It distorts a perception of decision-making and
risk. Many investors, both individual and institutional, operate
on the belief that a loss should be followed by a greater risk in
order to achieve some form of justice. The fact that even
experienced investors might fall into this fallacy of thought is
disturbing. A rational view of a loss is that it should be accepted
and if any change to strategy is to be made it would be prudent
to exercise greater caution to reduce the chances to recurrence.
Another instructive aspect of loss is the lesson that cutting
losses early rather than seeing them through makes more sense
than magically thinking the outcome can be influenced apart
from rational cause and effect.
This fallacy also applies when investors tell themselves that
losses occurred because they deserved to suffer or that losses
are instructive on a moral or even religious level. However,
trend analysis is a scientific method for identifying changing
attributes in trends, such as a weakening of the cure in a trend
based on indicators and confirmation. Ignoring such signals
does lead to missing a reversal as it occurs. There is nothing
magical in this; trend analysis involves study and an
understanding of both supply and demand and technical
influences of price and the trends in which price moves.
For the serious investor, being aware of tendencies toward
magical thinking is useful in the sense that even logical and
rational analysts may develop blind spots. For example, if an
investor experiences an exceptionally high profit on one trade,
the human tendency is to look for actions that preceded a
decision and to try and repeat them. If those actions were based
on analysis, this is a logical process. But as a subtle aspect of
human thought, it is all too easy to fall into the blind spot of
post hoc, ergo propter hoc. In that case, even while thinking
logically, the analytical process could be affected by magical
thinking.
The next chapter examines the nature of resistance and
support and how these trading range borders bring discipline
to trend analysis. When trends remain within well-defined
trading range borders, the conclusion is that the trend remains
healthy and will continue. However, you will learn just as much
about the duration of a trend and potential reversal when price
breaks out of these borders. Knowing whether price will retreat
back into range or set up a new higher or lower range is
essential to trend analysis.

Endnotes
1 Fisher, Gregg S. “How to Protect Investments from Cataclysmic ‘Fat Tails.’” Forbes at
www.forbes.com (October 14, 2009).
2 Walker, Helen. Studies in the History of the Statistical Method. Baltimore, MD:
Williams & Wilkins Co., 1931, pp. 24–25.
3 Bollinger, John. Bollinger on Bollinger Bands. New York: McGraw-Hill, 2001.
4 Grimes, Adam. The Art & Science of Technical Analysis: Market Structure, Price
Action & Trading Strategies. Hoboken, NJ: John Wiley & Sons, 2012, pp. 196–98.
5 Clark, C.A. “Hypothesis Testing in Relation to Statistical Methodology.” Review of
Educational Research, 33 (1963): 455–73.
6 Fama, Eugene. “Random Walks in Stock Market Prices.” Financial Analysts Journal,
January–February, (1995): 75–80.
7 Myerson, Roger B. Game Theory: Analysis of Conflict. Cambridge, MA: Harvard
University Press, 1991, p. 1.
8 Poundstone, William. Prisoner’s Dilemma. New York: Doubleday, 1992.
9 Colman, Andrew M. A Dictionary of Psychology, Third Edition. Oxford, UK: Oxford
University Press, 2012, p. 436.
10 Glucklich, Ariel. The End of Magic. Oxford, UK: Oxford University Press, 1997, pp.
32–33.
11 Lévy-Bruhl, Lucient. How Natives Think. New York: Knopf, 1925, p. 36.
Chapter 3
Resistance and Support: A Trend’s Moment
of Truth
Breadth of trading defines volatility. A larger number of points
between resistance and support points to higher volatility,
compared to a smaller breadth of trading and lower volatility.
The trend itself can exist only because the levels of resistance
and support are recognizable. However, this can take many
shapes and sizes, and duration of a trend relies on whether or
not the breadth of trading holds up.
For swing trends, the levels of resistance and support might
be only a few sessions; or the swing trade itself is likely to occur
within the current breadth of trading as prices rise to resistance
and fall to support without breakouts. For secondary trends,
breadth of trading may involve testing of either resistance or
support. A price move opposite the direction of the secondary
trend may be a retracement, a swing reversal of varying
duration, or an actual change in the trend. For a primary trend,
a consistent and long-lasting breadth of trading indicates that
the trend is going to continue; once the breadth of trading
broadens or narrows, it is a signal that the primary trend might
be coming to an end. If a breakout occurs, it could be the first
sign of a reversal or, if the breakout holds, it could signal strong
continuation. Momentum and volume are strong confirming
signals at the point of breakout.
Tests of Breadth

To understand the behavior of resistance and support, a

starting point may be the analysis of advances and declines in
the market as a whole. This is most useful for comparing the
behavior of an individual stock in comparison to the larger
market.

Key Point: The advance-decline (A/D) line for individual stocks is

more reliable than weighted index trends. It focuses on one
stock rather than on a group of stocks.

The A/D line is a measurement of all stocks on an exchange or

index. This measure offsets the tendency for weighted index
influence from a few issues and provides a picture of how the
market is behaving and on how an individual stock is likely to
follow suit with the broader market. This line is a cumulative
sum of the day-to-day differences between advancing and
declining stocks. However, one potential flaw is that it
measures only the number of stocks advancing versus those
declining, without adjustment for the extent of change in values
for either group.
The formula for the A/D line is:
(A – D) + P = A/D
A = number of advancing stocks
D = number of declining stocks
P = previous advance/decline line

The A/D line identifies whether market participation is stronger

among buyers or sellers. This is applicable to a large number of
stocks, so the usefulness of the A/D line by itself is limited when
analyzing a single stock’s price behavior. If the market has a
series of straight upward or downward movements, the
applicable A/D will reflect the trend. However, there are always
advancing and declining stocks in any market condition. Each
day’s advancing (minus declining) outcome is added to the
previous (P) line. When the market line is compared to the
trend of an individual stock, it demonstrates how that stock
compares to the overall market.1
The A/D line can set up a form of divergence with individual
stocks (or with other index measurements). A divergence
appears whenever the overall market and individual stock
move in opposite directions. For example, buyer participation
appears to be dropping for the overall market but an individual
stock’s breadth of trading is on the rise. This is a bullish
divergence. When the opposite occurs (increasing advancing
issues versus a decline in the breadth of trading of the stock), it
is a bearish divergence. Although significance is given to
divergence by many technicians, it often merely points out that
large-scale movement is nothing but an average. Each stock
moves for its own technical reasons and cannot be expected to
conform to broader market trends. Divergence, as a result,
might not hold special significance. However, it is one aspect of
a stock’s beta (represented by the Greek symbol β), or a
tendency for a stock to move with the market or more (or less)
than the market.
Assuming the overall market holds a beta of 1, stocks can be
compared. A stock’s beta below 1 indicates either lower
volatility than the broader market or a lack of correlation
between the stock and the broader market. For example, the
price of gold often moves opposite of the market. So testing gold
through an ETF like GLD, the beta is likely to be quite high
(either positive or negative) because gold will not follow the
market for stocks.2
Beta is also useful in quantifying the immediate risk or
volatility within a stock price based on beta over a range of
dates. One writer proposed that under a method for evaluating
a portfolio, “risk would be defined in terms of uncertainty,
rather than simply as risk of loss. . . . Any portfolio involving
risk above [beta] would, by definition, be speculative.”3
When applied as a method for measuring risk, beta aids in
spotting the associated risks in current trends. This is more
insightful than the A/D line, which provides directional
conclusions without including scale. The A/D line is not
especially useful if looked at in isolation. It provides confirming
or contradictory information about single stocks relative to the
broader markets, but nothing more. When divergence appears,
analysts should look for signals that forecast reversal or
continuation and strong confirmation of patterns in price,
volume, or momentum. The A/D line by itself is not specific to
the stock and should not lead to any decisions without further
investigation, including a study of beta. However, when the A/D
line changes from one side to the other, the influence of the
overall market on individual stocks is one of many important
signals. If similar but subtle changes are observed in the
breadth of trading, it could foreshadow trend changes to follow.
Among the reasons to use the A/D line cautiously is the lack
of distinction between small or large moves in either direction.
It is simply a count of the number of stocks advancing versus
those declining. So a large move in the broad market looks the
same as a modest move. Looking at this in another way, it
means that a move in a $200 billion capitalization company is
counted in the same manner as a move in the same direction
for a company with only $10 billion in capitalization. The
differences in the significance of advances or declines between
these companies is obvious, but the A/D line makes no
distinction between them.
As a breadth indicator, the A/D line is limited in its
application. It measures participation in either direction. Its
degree of movement has to also be taken with caution,
however. Much of the relative movement of the line depends on
the timing of a starting point. This is accumulative
measurement, meaning it will appear differently when
dissimilar starting points are used.

Key Point: A drawback in the A/D line is that its results rely on
the selected starting point for the analysis.

Given the limited applicability of index-wide measurements

like the A/D line, it should be recognized as only one of many
possible indicators to judge the condition of the market as
generally bullish or generally bearish. While individual stocks
might tend to follow the overall market’s direction, there is no
hard-and-fast that they must. Each stock reacts to the company
fundamentals, momentum, and technical signals as well as to
the larger market.

The Nature of Resistance and Support

A definition of support and resistance should be agreed upon in

order to delve into a more advanced discussion. To define both:
“Support is a level or area on the chart under the market where
buying interest is sufficiently strong to overcome selling
pressure. As a result, a decline is halted and prices turn back
again. . . . Resistance is the opposite of support.”4
Trends are defined by the attributes of resistance and
support. The price points of these borders to the trading range
are visual representations of supply and demand, and activity
of price within these two prices reflects the short-term effects of
many influences. Earnings, mergers, and dividend
announcements are examples of fundamental events that
directly influence price movement and continuation or reversal
of all types of trends. Technical signals include double tops and
bottoms or head and shoulders patterns based on the idea that
a failed breakout leads to price movement in the opposite
direction; candlestick signals add an even richer variety of
reversal and continuation signals and confirmation. Although
these signals are closely associated with swing trade timing, it is
equally crucial to determine whether or not the current trend is
likely to continue or end. Signals are also found in price
patterns formed as moving average signals, volume signals, and
momentum oscillators. All of these will be found within existing
trends and all may be found as trends weaken and start to
forecast reversal.
An initial understanding of the supply and demand forces
points out that excessive supply of shares at the current price
will drive prices down and that support is the lowest price in
the supply cycle. A scarcity of shares at the current price drives
prices up and resistance is the highest price in the demand
cycle. However, a point eventually occurs in which either
supply or demand side price activity gathers momentum and
crosses over resistance or support. The causes for this are many
and cannot be simply assigned to distortions in supply and
demand. Among the influences is market psychology, a
tendency among traders to overreact to current news and to
follow the trend rather than to anticipate when the trend is
likely to end.
Much of the signaling that is used to identify turning points
in trends, whether swing, secondary, or primary, is likely to
occur at resistance or support, especially when price gaps
through in a breakout. At that point, reversal is most likely.
However, if continuation signals are found and confirmed, the
breakout is likely to succeed. However, any confirming signals
should be confirmed with equally strong additional signals. The
proximity of price to resistance or support is the most
important determining factor in where price moves next, and
in whether or not a current trend will continue or reverse.

Key Point: Resistance and support levels and price proximity to

them are the points where reversal is most likely.

In understanding resistance and support, the initial significance

is a factor of supply and demand characteristics; however,
there is much more to consider in the technical attributes of a
trend. Resistance is the price level where selling activity is likely
to prevent price from moving through that border. As price
advances close to resistance, buyers become less inclined to
buy, knowing that the likelihood of price continuing beyond
resistance are slim. At the same time, and for the same reason,
sellers are more likely to enter sell orders as price moves
higher. So this weakening of the bullish move by both buyers
(less inclined to buy) and sellers (more inclined to sell) explains
why resistance is more likely to hold up than to break down.
This is why breakouts, especially with gaps, are aberrations in
the orderly interactions between buyers and sellers and why
reversal is most likely at that point.
Support is the exact opposite. It is the lower border of the
trading range representing the price at which demand remains
strong enough to prevent any further price decline. As price
reaches support, buyers are likely to pick up buying activity
because prices reach bargain levels. And sellers become less
likely to sell. So this combined activity tends to cause price to
hold at support and to move back toward the middle of the
trading range. Just as price may break through resistance at the
top, it can also break through support at the bottom.
A breakout accompanied by price gaps is most likely to
reverse. Swing traders look for such moments, realizing that
proximity to support with gapping price movement is the most
likely point for reversal. However, if continuation signals
appear at this point, it is possible that a new, lower trading
range will be established.
These “rules” of supply and demand are simplifications of
how price movement works. Many additional influences are at
work in determining trend behavior, and supply and demand
cycles are only one of those influences. Both fundamental and
technical causes are equally influential in how trend movement
occurs, both in the short term and over many months in a
primary trend.

The Channeling Trading Range

When a stock is trading within a dynamic trading range, it is a

“channeling” stock. Thus, a stock’s price may rise or fall in the
channel without changing the breadth of trading. This is the
distance between high and low price, and even as a stock’s price
moves up or down, the distance remains constant, thus the
description of a channel. However, unlike a flat, sideways-
moving resistance and support level, in the channel, both
resistance and support rise or fall in unison. It is a set of two
trend lines (one each for resistance and support, evolving but
maintaining the breath if trading) moving in the same direction
and to the same degree; this is commonly found in stock charts
and channel lines (this is illustrated in figures found in Chapter
4) and not distractions from the current trend, but strong
confirmation that the trend is consistent. As long as it is on the
move (a) in the same direction, (b) with the same breadth of
trading, and (c) without breakouts in either direction that
persist (other than short-term retracements), it adds strength to
that trend.

Key Point: Channeling prices—trending with an unchanging

breadth of trading—visually identify the continuation of the
current trend.

In a channel, the trading range is well-defined, meaning that

the distance between top and bottom remains the same even as
the price rises or falls. Channels may be ascending, in which the
breadth of trading holds to the same point spread but prices are
on the move upward. They may be descending, in which the
price levels decline. And they may be flat, with sideways price
movement representing a period of uncertainty, a struggle
between buyers and sellers.
An example of a chart containing both flat and ascending
channels is seen in Figure 3.1.
 Figure 3.1: Resistance and support—flat and ascending channels
Source: Chart courtesy of StockCharts.com

The year 2012 was represented by a flat channel with only a 10-
point breadth of trading. However, for most of 2013, an
ascending channel was in effect but with the same average
breadth of 10 points. In 2014, the trend hit a plateau and
returned to the flat variety, still with a 10-point breadth.
Although the three-year price trend moved dramatically, the 10-
point breadth of trading was witnessed both in the flat periods
(2012 and 2014) and in the channel trend (2013).
The consistency of this pattern, not only in duration of each
of the three phases, but also in the breadth of trading,
demonstrates the strength of channeling stocks. In the chart,
three distinct secondary trends occurred, flat during the first
and third years and ascending in the second year. An
examination of Boeing’s chart before and after the period
reported shows that the stock was in a long-term primary
trend:

Year Range
2009 $40–$55
2010 $55–$60
 2011 $60–$67
2012 $67–$75
2013 $75–$135
2014 $135–$135
2015 $135–$150 (2.5 months)

The pattern goes from flat to ascending, repetitively. So between

2009 and the first quarter of 2014, the overall trend was
between $40 and $150 per share, a 375 percent growth in the
price over 6.25 years.5
The remarkable aspect of this channeling stock trend is how
consistently the breadth of trading held through several years.
The levels of resistance and support between 2012 and 2014
were easily identified, both in periods of flat and ascending
channels. This makes tracking and prediction based on the
resistance/support relationship very dependable. You can not
know how long the flat or ascending period is going to last,
however. For example, in two and a half months of 2015, the
stock price rose 20 points, twice the rate of the previous six
years. This is a potentially troubling change. It could signal the
coming of an adjustment, especially since the company had no
downtrends of any duration for the entire period. It could also
be a temporary change in the breadth of trading that will settle
down into a more familiar pattern like the one established
between 2009 and 2014.

Reaction High and Low Prices

Both resistance and support can be identified by location of

reaction high and reaction low prices. A reaction high is a price
peak appearing during an in-range movement in price. The
movement itself may be sideways or trending up or down;
however, reaction highs are likely to occur following a
downward movement, and the high price will set resistance. A
single occurrence is not enough, however; resistance can be
drawn on a series of reaction high prices.
The reaction low is the opposite. It is a price downward
spike occurring within range, often offsetting (reacting to) a
short-term rise in price. To set support, find a series of reaction
low prices.

Key Point: Identifying a new level of resistance or support

depends on two or more price spikes after a movement to a
revised breadth of trading. Once the established breadth is
violated, the previous resistance or support becomes invalid and
a new level is set.

The reaction levels—both high and low—represent failed

attempts at breaking through resistance or support. For short-
term trading, these points clearly draw the “line in the sand”
where trading is thought to not violate. However, swing traders
seek moments where price does move through those
established reaction prices (especially with price gaps) so that
the timing of a reversal trade makes sense.
For longer-term trend analysis, reaction high and low prices
mark resistance and support for the duration of the trend.
These may be violated through retracement moves in either
direction, especially in narrow breadth of trading. However,
once price begins repeatedly breaking through and then
retreating, it implies that breadth of trading is broadening, or
that a breakout will eventually succeed. So the current trend
may be ending or, on the other side of the range, expanding.
 To interpret reaction high and low moves correctly, they
have to be confirmed with other price, volume, or momentum
signals. However, the activity surrounding resistance and
support levels does indicate the threat that a current trend may
be ending. Tracking the reaction moves within the trend often
reveals coming breakout.
A problem with reaction price movement is that rather than
signaling trend movement, it could simply be an attribute of a
particularly volatile price situation. Such charts are difficult to
read. When prices continually test resistance and support with
reaction high and low moves, it is difficult to determine
whether the trend is in effect. It is equally difficult to determine
which direction a breakout will take. Reaction high prices may
consist of a series of “M” high or double top formations, offset
by a series of “W” low or double bottom signals. When this
offset occurs repeatedly without price breaking out, the
contradiction in signals negates both. Rather than viewing the
reaction price movement as a signal, it is more likely to signal
volatility and uncertainty in which direction price will move.
Although volatility of this character often is associated with
short-term price activity, it also may exist in longer-term trends
and create a chronic state of volatility. Such patterns may
exhibit breakouts, but these may be short-term in nature and
offset a high breakout with a low breakout. Even for longer-
term trends, the excessive reaction pricing is difficult to predict.

The Bouncing Price within a Trend

The offsetting reaction high and low price pattern is especially

difficult to interpret when resistance and support are both
moving in a flat progression. With rising or falling price trends,
the offsets can be interpreted by comparing price to volume
and momentum signals; however, when the reaction bounces
between an established high and low levels, you may see
breakouts in both directions, repetitively and without
identification of any clear trend to follow.
The longer this situation endures, the less trust should be
invested in the appearance of any price movement that seems
to be holding. The past experience of short-term breakout
makes the sideways trading range stronger, but adds great
uncertainty to the ability to forecast any new trends. While
some signals are strong and specific, the bouncing range is both
volatile and uncertain. For example, Figure 3.2 included a
sideways-moving bouncing range for more than one year, with
short-term breakouts in both directions.

Figure 3.2: Resistance and support—bouncing range

Source: Chart courtesy of StockCharts.com

The trading range in this three-year period was volatile. It

ranged between $90 and $135. The year 2013 and beyond was
characterized by a sideways-loving range from resistance of
slightly above $120 to support slightly above $110. Price within
this range consisted of four reaction high moves culminating in
a breakout lasting three months and three reaction low price
moves resulting in a two-month breakout below support.

Key Point: Trends do not always emerge after a volatile price

pattern. Reaction high and low trends may indicate the lack of a
new primary trend.

As of year-end 2014, it was impossible to determine any

emerging trend or direction for the price. Volatility continued.
By mid-2015, CVX decline under $65; by early 2018, it rose to
$130. And by January, 2019, it had fallen to $109.
The activity between high and low reaction prices was not
only volatile, but contradictory as well. In a case like this,
determination of whether to trade or forecast any trend, you
would need more information about volume and momentum;
however, indicators confirming price are only valuable when
clear trend movement has been underway and you seek
confirmation of reversal. In this case, no clear trend existed. So
the best course would be to wait until a primary or secondary
trend becomes established and to then analyze price and
attempt to confirm the strength or weakness of the trend. Until
volatility settles down, this is a challenging requirement and
could be difficult or impossible.

The Flip

One of the most revealing patterns in resistance and support is

the flip. This occurs when previous resistance becomes a new
support level or when previous support forms as new
resistance.
 In these occurrences it often becomes clear which direction
a trend is taking. It is also true that after the flip the newly
established resistance or support level tends to be exceptionally
reliable—not always, but often. To draw this conclusion, you
should rely on not only price action but also on confirmation.
The exceptional aspect of the flip is that it signals a transfer
from demand to supply (on the downside) or from supply to
demand (on the upside). This is a strong transfer, which
translates to strong newly established price limits on either
side.
An example of a flip from resistance to support is found in Fi
gure 3.3. This bullish trend is strengthened and confirmed by
the clear transfer. The three tests of newly established support
on October 2013, February 2014, and October 2014 were all
weak and none succeeded. Price continued to rise in a firmly
established bullish trend.

Figure 3.3: Resistance and support—flip (resistance to support)

Source: Chart courtesy of StockCharts.com

The upward trend actually began in July 2012 when price had
dipped below $80 per share. By the end of 2014, price had risen
to $145. Based on the strong and long-term growth in the stock
price, and also on the flip to new support at $120 per share, the
bullish primary trend in this case appears to be well
established. It is not likely to change unless that support level is
successfully violated and confirming bearish signals appear.
A bearish move may consist of a flip from previous support
to new resistance. An example of this was seen in a more
volatile pattern shown in Figure 3.4.

Figure 3.4: Resistance and support—flip (support to resistance)

Source: Chart courtesy of StockCharts.com

The previous trading range, lasting more than two and a half
years, moved in a 33-point breadth of trading, between $167
and $200, with some limited failed breakouts above. A triple
bottom formed between October 2013 and February 2014,
creating reaction lows. However, price following this remained
below $195, a sign that the range was narrowing. Price gapped
lower and fell below support to set a new resistance level below
$165 per share. This newly established resistance level held for
at least two and a half months, so it clearly was a flip from
support.
Key Point: When resistance and support levels flip, it often
points to a stronger than average hold on those breadth levels.

The volatility within range preceding the flip had ramifications

for long-term trend analysis. The price was range-bound for so
long that the move below support, occurring for the first time in
nearly three years, was notable, not only due to the duration of
prior support, but also due to the strong decline with a nearly
20-point gap but also a steep decline from above $190 down to
as low as $150 in only three months.

Wedge-Shaped Trends

The wedge is a commonly appearing pattern with two lines, one

sloping upward and the other sloping downward. The pattern
shows price range narrowing as the lines move toward one
another. Some wedges are not especially strong signals,
however. The more pronounced the slope of the wedge and the
more rapid the narrowing range, the stronger the reversal
signal is likely to be. The wedge is used as a confirming pattern
in swing trading, but repetitive wedges also forecast coming
reversal in longer-term trends.
The rising wedge is bearish and anticipates reversal once the
breadth of trading has narrowed. In order to work as a
legitimate bearish reversal, the wedge must appear after a
period of bullish price movement. In a primary trend, the
wedge may take six months to one full year, and in a secondary
trend you would expect the wedge to average three months in
duration. However, there are no set rules for its duration.
You also expect to see two or more reaction highs form the
wedge’s resistance level. On the bottom side of the wedge
expect to find at least two reaction lows to form support. The
turning point occurs once the established support line is broken
after which price is expected to decline in confirmation of the
bearish nature of the wedge.
An example meeting these criteria is found in Figure 3.5. The
bullish trend began with the low price under $60 at the end of
June 2012. Since that point, prices rose for two years through
June 2014. The wedge formed from mid-2013 to mid-2014. The
resistance level was marked by two reaction highs, at October
2013 and at April 2014. Support was marked beginning in June
2013 with reaction lows at February 2014 and in March 2014.

Figure 3.5: Resistance and support—rising wedge

Source: Chart courtesy of StockCharts.com

The support line ended once prices declined in September 2014

and the bearish wedge was confirmed as prices fell below
previously established support.
A falling wedge is bullish and has to follow a bearish trend.
A strong example meeting the criteria of a falling wedge is
found in Figure 3.6.
 Figure 3.6: Resistance and support—falling wedge
Source: Chart courtesy of StockCharts.com

The downtrend began after the high price level of $95 in

September 2012. The decline lasted until April 2013, with the
falling wedge marking the bear trend clearly. Several reaction
lows are found along the declining support and reaction highs
were found along the declining line of resistance. Confirmation
of the bottom of the bearish trend is found in the double bottom
forming in April and July 2013.

Key Point: Wedge formations—narrowing breadth trends—

forecast reversal, although the timing of the actual reversal relies
on confirmation.

After the bottom was confirmed, a strong uptrend followed for

the next eighteen months through to the conclusion of this
chart. This pattern demonstrates an exceptionally clear
reversal, anticipated by the falling wedge and confirmed by the
double bottom. In this chart, the bear trend between 2012 and
2013 was probably a secondary trend, but the last eighteen
months of the charted period represent a net bull primary
trend for this stock. During this time the stock price more than
doubled.

Triangle-Shaped Trends

Another formation, potentially setting up strong continuation

patterns, is the triangle. Unlike the wedge, which is a reversal,
the triangle is a continuation pattern. The ascending triangle is
bullish. This means it has to be found during an existing
uptrend. It consists of a flat resistance with at least two reaction
highs and rising support with at least two reaction lows. The
triangle narrows until price levels break through and rise
above resistance, ideally forming a new support on a flip from
resistance.
An example of the pattern is found in Figure 3.7.

Figure 3.7: Resistance and support—ascending triangle

Source: Chart courtesy of StockCharts.com

The uptrend began at the same time as the rising support of the
ascending triangle, at the beginning of June 2012. It continued
for more than a year, making it likely that this was either a
secondary trend or the beginning of a new bullish primary
trend.
Resistance contained several reaction highs but was not
violated until late May 2013. Support contained two reaction
lows at April and June 2013 before price fell lower temporarily
in late August. However, the continuation was confirmed as the
price level rose strongly above the previous resistance of $87.50
per share. Resistance flipped to become support, and this level
of $87.50 was tested with three attempted breakouts, but none
held. This strengthened the assumption that this support level
would hold. Following the period shown, price did test support
twice more, on February 15 and between January 28 and 30,
2015. However, none of these breakouts held and price
continued moving higher.
The descending triangle is an equally strong continuation
signal in a bearish market. It requires existence of a current
downtrend. An example of this pattern in a primary bearish
trend is seen in Figure 3.8.

Figure 3.8: Resistance and support—descending triangle

Source: Chart courtesy of StockCharts.com
The period beginning in 2012 does not clearly mark a
downtrend. Looking back, the price of USO was at $47 per share
in May 2011 and declined from that point to the beginning of
the period shown. The overall trend is bearish, with the chart
concluding below $20 per share, a drop of more than half its
value from beginning to end of the chart.

Key Point: Wedges are reversal signals, but triangles indicate

continuation of the current trend.

The flat pattern from late 2012 until late 2014 represents a
pause in the bearish trend. The resumption of the price drop
was anticipated by the descending triangle appearing between
July 2013 and October 2014. This consisted of level support with
reaction lows in December 2013 and in January 2014; and a
breakout below this established support level in early October
2014.
On the top side, the descent of resistance occurred in two
steps, from October 2013 through February 2014, and again
between July 2014 and October 2014. Both of these falling
resistance lines included at least two resistance high points.
This could be viewed as two separate descending triangles, or
as one long with a rally in between. In either case, the longer-
term trend was a primary bear trend, and the descending
triangle confirmed it.
The third type is the symmetrical triangle. This is the least
useful of the three types as it can be either bullish or bearish.
Although it is supposed to act as a confirming signal, it can also
represent reversal of a secondary trend. The unclear meaning
of the symmetrical triangle—as either bullish or bearish and as
either reversal and continuation—makes its usefulness less
than clear. An example of this pattern is seen in Figure 3.9.

Figure 3.9: Resistance and support—symmetrical triangle

Source: Chart courtesy of StockCharts.com

The longer-term history of this stock appears to be bullish. It

moved from about $1.50 per share at the beginning of 2009 to
$3.25 in 2010 and $3.70 in 2011. So the long-term trend appears
to be bullish. However, during 2014, the price fell from above
$11 down to about $4 per share by the end of the year.
Therefore in this example, this makes the symmetrical triangle
a reversal. In analyzing the trend, relying on the symmetrical
triangle by itself is not suggested. You need stronger signals and
clear confirmation before deciding whether a pattern means
continuation or reversal.

Support and Resistance Zones

Although resistance and support are most often represented as

single lines, they may also be shown on charts as zones.
Typically, the lines are drawn between reaction high and
reaction low points. In some patterns, zones more accurately
show the likely formation trend.
Because precise resistance and support levels are not always
apparent, the zone approach allows you to map out the course
of a trend without rigid compliance with rules. For example, if
price breaks a trendline, does that mean the trend itself has
ended? This could signal the beginning of a reversal formation,
but not necessarily. Every price pattern and every form of
confirmation sets up in its own way. So trend analysis has to be
a flexible science based on a combination of observed
developments, signals, and confirming indicators. The
resistance and support zone can aid in this process.

Key Point: Clear price points for resistance or support are not
always apparent. At such times, resistance and support zones
add flexibility to trend analysis.

An example of resistance zone is found in the chart in Figure 3.

10.

Figure 3.10: Resistance and support—resistance zones

Source: Chart courtesy of StockCharts.com
The range between $55.50 and $56.75 is treated as a resistance
zone in this chart. The location of resistance elsewhere is less
certain. The prices of $55, $56, and $57 could all be considered
as resistance on the basis of recurring reaction high prices.
However, the multiple M high formations touching all those
price points create doubt concerning the appropriate resistance
price. When viewed within the zone, however, those M
formations at July–August 2013, October–December 2013, April–
May 2014, July–August 2014, and August–September 2014 all
approach different high price levels before the breakout on
October 2014.
In comparison, the support price does not need to be
expressed as a zone, as it is clearly set at $50 per share
throughout the period charted. The resistance zone applied
here not only adds certainty to analysis of the sideways
movement of price in the 5- to 7-point range. It also highlights
the repetitive “M” tops. The attempt followed each “M” top to
lead to price decline failed to move below the $50 support. In
fact, starting in June 2014, support appeared to be rising, setting
up the appearance of an ascending triangle against the
resistance zone. This predicts the strong price breakout that
quickly followed.
Support zones function in the same manner, often clarifying
the true level of support as a price range rather than as a
specific price. Figure 3.11 provides an example of a chart with
not only one, but two distinct support zones.
 Figure 3.11: Resistance and support—support zones
Source: Chart courtesy of StockCharts.com

The first support zone extends between $42.75 and $47.50 per
share. An attempt to select a single-price support zone within
this range presents several problems. Support at about $43 per
share could work based on the eighteen-month extension, but
in between several other prices appear to provide interim
support levels as well. So $45.50 and $46.00 per share could
have worked as support levels if there were more consistently
in the duration.
The resistance fell twice within the period of the support
zone, setting up descending triangle patterns foreshadowing a
price decline. The third instance of falling resistance set up the
second support zone between $32.50 and $33.50 per share. At
the same time, resistance price appeared to stabilize at $37.50.
Support could have been selected to reside at several points
during this six-month period; however, using a support zone
made more sense because it held and brought the appearance
of order to the chart.

Key Point: When specific price points are not obvious, resistance
and support zones provide the same clarity in defining the
breadth of trading.

Dynamic levels of resistance and support often are difficult to

interpret. A level and firm price line moving sideways is easy to
test based on whether or not price is able to breakout above
resistance or below support. However, when resistance and
support are both rising or both falling, it is not as clear how
strong or weak the trend is, especially a long-term trend.

Breakouts as Signals of Supply and Demand

Adjustment

The entire nature of trends is changing constantly even as the

trend moves consistently. When the trend is moving sideways
for an extended period of time, analysis and forecasting is more
difficult because there is no dynamic trend to reverse. However,
when trends are rising or falling, a key indicator is a breakout.
By definition, resistance and support are supposed to prevent
breakout from succeeding, confirming that the current breadth
of trading is holding. If a breakout does succeed, it means
something has changed.
When a breakout succeeds in the direction of the existing
trend, it not only confirms the trend but accelerates it. In an
uptrend, successful breakout above resistance means that even
while buying pressure (caused by excess demand) was in
control, that pressure has increased. In a downtrend, successful
breakout below support means that selling pressure (caused by
excess supply) was in control of the trend, and that pressure
has increased.
Any time that price moves outside of the established breadth
of trading, it causes concern. The typical understanding of
breakouts in a direction opposite of the trend is that a reversal
has begun. However, it could represent one of three events.
First is a complete reversal in the primary or secondary trend;
second is a temporary offsetting trend (secondary within the
primary or swing within the secondary); and third, the
offsetting price could be a retracement in which case price
should return to its established range.
Even with these observations of shifts in supply and demand
(with breakout meaning one side has lost and the other has
won), many additional causes lead to reversal. These may be
well beyond the forces of supply and demand and may include
market competitive position, fundamental changes, and
technical aberrations in price. Many price moves occurring
over the long term are factors of beta. A number of trends,
especially secondary trends, may exceed the overall market’s
trend in the same direction. The extent to which individual
stocks are influenced by the market, and to which that
influence is reflected in beta, is not a precise matter. It is also
likely to change over time. Beta explains a lot in the short term,
but for longer-term trend analysis, the price range and trend
direction are more likely to be influenced by the fundamentals:
revenue and profit growth, P/E ratio, dividend yield, and
control over the level of long-term debt as a percentage of
capitalization.
Aiding in interpretation of dynamic breadth of trading are
the trendline and channel line. These technical tools help trend
analysts to (a) spot duration, (b) see changing slope as the trend
evolves, and (c) distinguish between reversal and retracement.
The next chapter explores the nature of trendlines and channel
lines.
Endnotes
1 Dworkin, Fay. “Defining Advance-Decline Indicators.” Technical Analysis of Stocks &
Commodities, July 1990.
2 To find a stock’s beta, use an online calculator like the one at https://www.buyupsid
e.com/calculators/beta.php
3 Rizzi, Joseph V. “Portfolio Theory, Capital Markets, and the Marginal Effect of
Federal Margin Regulations.” Loyola University, Chicago Law Review, 8, issue 3
(Spring 1977), at http://lawcommons.luc.edu/lucli/vol8/iss3/3
4 Murphy, John J. Technical Analysis of the Futures Market: A Comprehensive Guide to
Trading Methods and Applications. New York: Prentice Hall, 1986, p. 59.
5 www.StockCharts.com, through first quarter, 2012.
Chapter 4
Trendlines and Channel Lines: The Shape of
Things to Come
Trends are clearly shown through drawing of trendlines and
channel lines. These are among the most basic of indicators and
they bring the trend to life by outlining the slope and duration of
a trend with great clarity.
Even though the trendline and channel line are easily viewed
and understood, they also support numerous related indicators,
notably highlighting the differences between retracement and
reversal and how trends are managed by analyzing short-term
patterns like flags (which are four sided) and pennants (which
are triangular).

Signal Patterns versus Trends

A price pattern tends to be short term in nature and points to

the immediate tendencies of price. For example, a double top or
double bottom strongly forecasts reversal in the direction of
price, and these are especially compelling when occurring at
resistance or support levels. However, they reveal only what is
occurring in price strength or weakness of the moment.

Key Point: A price or signal pattern is an immediate indicator of

change, but not always a sign of trend reversal. It may indicate a
move within the current trend’s breadth.
The same is true for candlestick signals, momentum oscillators,
moving averages, and volume levels. All of these, by themselves,
relate to price patterns and are useful as part of a swing trading
strategy. However, for longer-term primary and secondary
trends, these short-term signals are of limited value by
themselves.

Used in combination, however, these signals can forecast

primary and secondary trend reversals. For this to effectively
signal a change in the trend, several elements should be in place,
including:
1. Proximity to resistance or support. The closer to these all-
important price levels you find reversal signals, the greater
the likelihood of that reversal occurring. This applies to
swing trends but also to primary and secondary trends,
assuming other elements are also present.
2. Signals of exceptional strength, preferably multiple signals.
The price signal is one possible way to forecast reversal;
however, volume, moving average, and momentum should
also be considered in determining whether a reversal signal
is minor or major. This also helps distinguish between
reversal and retracement. A retracement tends to appear
with no specific signal and is likely to act like a swing trend,
lasting only a few sessions in most cases.
3. Confirmation of equal strength to the signal(s). Confirmation
is essential in the establishment of reversal. Just as the Dow
theory requires confirmation between separate averages,
individual stocks rely on confirmation between separate
signals.
4. Strong trends that are likely to reverse. Statistically, the
longer a trend moves in one direction, the more likely it will
slow down or reverse. When you have tracked an especially
 strong trend (strong in the sense of angle and time), you
seek exceptionally strong reversal and confirmation signals.
The strength of a trend often is associated with the strength
of the reversal patterns and signals.
5. Combinations of signals, including price, volume, moving
averages, and momentum oscillators. All these signals are
useful in timing swing trades, but when used together to
seek reversal for primary and secondary trends, they
provide a powerful combination of signals. In comparison, a
weak signal or worse yet, contradictory signals, confuse the
issue and are likely to give out a false indicator about
reversal.

In making a distinction between primary or secondary trend

reversals, and the shorter-term gyrations and swing trades most
stocks experience, specific attributes create short-term
uncertainty, contradiction, and retracement. These include a
tendency for many traders to follow the popular current move,
also called “herding,” in which a short-term trend is prolonged
due to greater activity—in a sense, jumping onto the trend in the
belief it is going to continue. However, herding invariably is
short term. So, unusual moves in price are likely to work as
swing trends and lacking strong reversal signals in combination
should be ignored or traded contrary to the popular actions of
other traders.

Key Point: A tendency toward crowd following, or herding, leads

to ill-timed trades and errors in understanding what a price signal
means.

The reasons for patterns as they emerge are not immediately

clear; however, they can be observed in charts and used to time
swing trades. For longer-term trades, the emergence of price
patterns, notably for reversal, presents a problem.
Distinguishing between a short-term reversal or retracement
and a longer-term primary or secondary trend change is elusive.
One study pointed out that, “While many technical trading rules
are based upon patterns in asset prices, we lack convincing
explanations of how and why these patterns arise, and why
trading rules based on technical analysis are profitable.” The
study also noted that confirmation bias is likely to “play a key
role in other types of decision making.”1
The tendency, especially among swing traders to seek
confirmation for what they believe is occurring rather than for
what is truly occurring, is self-deluding and leads to poorly
timed trades. In analyzing short-term price patterns, anyone can
find a signal that fits with their belief; acting on it, especially
when tracking primary or secondary trends, is an error. Even so,
this behavior is a chronic problem in trading. Longer trends
experience the short-term jumps in price in both directions, but
lacking confirmation in several forms, the swing trend should be
ignored by those who want to protect permanent equity
portfolio positions and prevent ill-timed trades.
Some programmed trading is based on models in which
selling activity increases in down markets and buying activity
increases in up markets, even when trend analysis might
suggest taking the opposite action. A contrarian will ignore the
activity that makes no sense based on trend analysis; however,
this risk management-based automated trading activity has the
effect of extending intermediate trends.
Focusing on primary trends requires paying very little
attention to swing trends and only cautionary awareness of
secondary trends. Effective trend-following requires observation
of trends on both the technical side and the fundamental side.
When price moves well beyond what the fundamental trends
justify, the result is easily measured by rising P/E ratio and
related tests. Investors who follow trends only with technical
indicators are prone to make mistakes in the timing of trades.
Fundamental analysis—the study of profitability,
capitalization and working capital of a company, in other words,
all things financial—provides a strong base for identifying long-
term trends and levels of price volatility growing from or
contradicted by fundamental volatility. However, timing of what
you gain from the fundamentals is less certain:
The advantages of fundamental analysis are its systematic approach and its ability
to predict changes before they show up on the charts. Companies are compared
with one another, and their growth prospects are related to the current economic
environment. This allows the investor to become more familiar with the company.
Unfortunately, it becomes harder to formalize all this knowledge for purposes of
automation (with a neural network for example), and interpretation of this
knowledge may be subjective. Also, it is hard to time the market using fundamental
analysis. Although the outstanding information may warrant stock movement, the
actual movement may be delayed due to unknown factors or until the rest of the
market interprets the information in the same way.2

By “outstanding” information, the statement above refers to

“known” information about the company. The observation was
offered that when it comes to the fundamentals, information
and reaction may lag so that an immediate impact is not always
seen.
As a technically based management tool for long-term trends,
the trendline and channel line are starting points for further
investigation. Upon viewing what appears a possible slowing
down or reversal of a trend, further confirmation should be
found and fundamental trends checked to confirm what appears
to be changing in the price trend.
Key Point: Trendlines and channel lines provide a structure for
further analysis, but changes in these lines require confirmation
before action is taken.

Trendlines and What They Reveal

Trendlines are straight lines drawn under a rising price move or

above a declining price move. The points from end to end are
the low points (in a rising trend) or the high points (in a falling
trend). The “perfect” trendline ends as soon as the price level
stops the line from moving farther without running into daily
activity. Temporary retracements or spikes violating the line can
be overlooked in the greater interest of tracking longer-term
price movement.
For example, in Figure 4.1, a bullish trend was underway for
the last two years of the three-year period charted. The line was
disrupted in February 2014 before the trend resumed. For five
months, the pattern was unclear until the upward movement
again resumed in November 2014.

Figure 4.1: Uptrend line

Source: Chart courtesy of StockCharts.com
Many attributes of the trendline are like those of resistance and
support. However, a distinction is that either of these trading
range borders may last longer than the trendline or may also be
established for shorter periods of time. For example, in the chart
in Figure 4.1, a case could be made to set a series of shorter-term
support and resistance levels even as price levels continued to
rise. The tendency for resistance and support to set up points at
which attempted breakouts fail do not always apply to
trendlines.
A declining trendline may also last for many months or, in
the case of the chart in Figure 4.2, show up as a series of declines
with some shared characteristics (gaps, rapid price movement,
and other price patterns).

Figure 4.2: Downtrend line

Source: Chart courtesy of StockCharts.com

The chart in Figure 4.2 is such an example. During the

downtrends, price fell rapidly and sharply. This was not a signal
of a bearish overall trend, however, noting that between August
2012 and December 2014 (nearly two years) the price range was
similar. This is more like a very volatile sideways price
movement (a consolidation trend) spanning 10 points.
Key Point: Volatile interim movements within a consolidation
trend may be deceiving; understanding the prevailing trend is the
first step.

The 10-point move between $37.50 and $27.50 lasted from May
2012 through December 2014. An interesting departure was seen
between November 2012 and August 2013. At the beginning of
this period, price gapped sharply upward nearly 5 points and
remained between $52.50 and $37.50 for the next nine months.
This was followed by a sharp downward gap of 7 points. This is
an unusual pattern that could be defined as a secondary trend
but appears more like an aberration in an otherwise established
longer-term primary trend with a lower range.
The volatility throughout this period, characterized by sharp
downturns in price as well as by large price gaps, supports the
suggestion that the middle-range price move was not typical of
the trend for this stock. However, the volatility itself makes it
very difficult to predict the next price move. The trends are not
long term, and they are not consistent. The repetitive downward
trendlines provide little guidance to management of the volatile
price. However, most of the price movement occurred in a 10-
point range. That is quite volatile given the typical price of this
stock; but it is not as volatile as a similar pattern would be for a
higher-priced stock.
A far more orderly version of trendlines is found in Figure 4.
3, which demonstrates a consistent level of secondary trends
alternating in direction. The first year was a bearish trend,
followed by two years of a bullish trend. Identifying the turning
point for this trend would involve studies of price, volume,
moving average, and momentum indicators.
 Figure 4.3: Alternating lines
Source: Chart courtesy of StockCharts.com

The price gaps and large downward dips in price ranges at the
very bottom of the downtrend provide a clue that a reversal was
about to occur, but to call this as the turn of a primary or
secondary trend would demand in-depth analysis of all signals
and confirmation. There was a volume spike at the very bottom
as well as a price gap. Both characterize a reversal, but lacking
more signals it was not clear whether this was merely a swing
trend reversal or a major primary trend change of direction. The
fact that the pattern did set up a new primary trend was not
evident merely from the volume spike and price gap. The
repetitive price gaps found over the next nine months as price
rose strongly were more reliable indicators of the new trend,
especially with the newly established trendline.

Price Increments on Charts

In determining whether trendlines exist in a high-volatility price

pattern or a low-volatility price pattern helps determine
whether the trend has stability and is likely to continue.
However, recognizing the level of volatility depends on the scale
of the chart.
Charts prepared through an online free charting service are
scaled automatically. The scaling is based on the time and the
total range of prices with the goal to fit all trading activity into
the chart’s rectangle. This means that with a narrow range,
scaling will also be narrow and with a very broad range, scaling
will be much greater. A consequence of this automatic scaling
rule is that comparisons of volatility are difficult. What appears
highly volatile might represent price movement in a narrow
range from high to low price.

Key Point: Scaling is set by trading range, so comparisons of

price movement or volatility between two or more stocks is not
accurate unless scaling is identical.

For example, Figure 4.4 contains a stock chart with a narrow

scale of prices ranging between $80 and $52.50 over three years.
 Figure 4.4: Narrow scale
Source: Chart courtesy of StockCharts.com

Although the price patterns on this chart appear to be volatile,

the degree of change rarely is greater than 20 points. In this
instance, volatility is limited to a small price range but it is
nonetheless a volatile history. Several trendlines are identified,
most of which were steep. A secondary pattern also was found.
In three instances, a sizable price gap was accompanied by a
significant volume spike. These two signals together were
compelling and tended to set up island periods of trading. In
these periods, one from January to July 2013 and the other from
June to August 2014, were initiated by the gap/spike sequence.
These could be considered as secondary trends and both had
another interesting characteristic. After the initial gap, the trend
moved opposite the previous price direction.
A chart such as this is difficult to track because the trends
within it were inconsistent. However, it would seem a good
candidate for a swing trading strategy. The long-term primary
trend moves from a low price under $52 to a high of nearly $80,
so it is bullish over the three years. With so much inconsistent
price movement within that trend, prediction is less certain than
for many charts.
A wide-scale example makes an interesting comparison. Figu
re 4.5 reveals a bullish trend of nearly two years with little
variation.

Figure 4.5: Wide scale

Source: Chart courtesy of StockCharts.com

The level of volatility in this chart is like the previous one in

terms of breadth of trading. Even so, it was more predictable
due to the greater scaling. The previous chart scaling in 2.5-point
increments and this one is scaled in 10-point increments.
Another oddity is that the scaling itself narrowed as the price
range rose. The chart gaps between $80 and $90 per share and
between $190 and $200 were considerably different. This
distorts the scaling and could deceptively create the appearance
of lower volatility.
This is a problem with trendlines on charts scaled differently
and when the scaling itself is altered within the chart. The slope
of this trend was much different than it appeared due to the
narrowing of spaces between price points. If the gaps were
reported consistently, the trendline would be shortened and
would reveal a lower slope of change during 2014, a year in
which the degree of change was lower than for 2013. This chart
reflected a three-year change in price levels from $75 up to $200
per share, a 125-point move. Volatility was considerable despite
its lower-volatility appearance.
In trendline analysis, changes in the slope caused by point
spacing not only distort the nature of the trend but may also
bring into question the significance of reaction high and lows. To
evaluate these properly, consistent scale is of great importance.
On the chart in Figure 4.5, the reaction level does not appear to
be significant. However, considering the narrowing scale during
the 2014 price range, the trend was more sideways than up, and
reaction high and low activity was volatile. This indicated that
the primary trend that began in March 2013 was slowing down.
By mid-February, the stock’s price was close to the level at the
end of the period charted.

Key Point: What appears as a dynamic price movement may be

nothing more than a slight move in the larger picture.

Analysts aware of how the changed price spacing affects the

appearance of the trendline might view 2014 not as part of a
continuing uptrend but as the beginning of a consolidation
period. This could also affect trade decisions based on likely
changes in the primary trend. The change in a trendline’s angle
is partially a factor of price spacing but also demonstrates
differences in trend volatility.

Trend Angles
When angles decrease as a trend develops, the tendency is for
support and resistance to strengthen. Conversely, when the
angle becomes steeper, resistance and support tend to weaken
and may disintegrate entirely as volatility throws the trend into
chaos.
This makes forecasting more difficult as steeper trends
represent growing volatility and uncertainty about price
patterns and the trend’s continuation. An example of a low angle
in trendlines is shown in Figure 4.6.

Figure 4.6: Low angle

Source: Chart courtesy of StockCharts.com

This chart reveals a series of short-term trends, all but one

moving upward as part of a primary bull trend. Over three
years, price moved from a low of $31 per share up to as high as
$45. Although the interim price patterns appear volatile, the
chart is spaced in 1-point increments. A 3- or 4-point move looks
extreme even when it is not. Over the entire period of this chart,
support (represented by the dotted line) rose consistently. The
short-term trends were applicable to swing trend activity or
could be treated as secondary trends, but as a separate matter,
support confirmed the bullish primary trend.
 Much less certain was the long-term trend for the next chart,
shown in Figure 4.7.

Figure 4.7: High angle

Source: Chart courtesy of StockCharts.com

This stock chart was priced in 2.5-point increments. Even though

the price spread was not substantial, the short-term changes in
price level and direction were steep. It was also consistent in the
back-and-forth changes between uptrend and downtrend. Most
lasted only two to three months. It appears that the moves
marked by trendlines were secondary trends within a primary
trend that was a consolidation not favoring either bullish or
bearish direction. From start to finish the price ranged over 35
points, but the net change was only 15 points, not much
movement over three years (from a starting price of $87.70 to an
ending price of $72.50).

Internal Trendlines

Trendlines cannot always be drawn to reflect an orderly and

consistent trend. At times, reaction high and low prices spike
outside of an otherwise recognizable trend. In these cases, an
internal trendline may clarify what is occurring in the broader
trend.

Key Point: Short-term volatility obscures the current trend so

that trendlines are not easily located.

This is a method in which the interim price spikes are ignored in

favor of showing what is occurring in a sensible manner. For
example, in Figure 4.8, several price spikes made it difficult to
spot the secondary trends taking place. However, by ignoring
those spikes the trendlines made the situation obvious. A series
of three secondary trends (alternating between bullish and
bearish) characterized this chart.

Figure 4.8: Internal lines

Source: Chart courtesy of StockCharts.com

Another interpretation of this pattern would be to call the first

and third bullish trendlines part of a continuing bullish primary
trend, with the middle bearish trendline marking a secondary
trend. The price moved over three years from an initial low of
approximately $29 per share up to a high approaching $42 per
share.
 The internal trendline is appropriate only if the violations of
the line are true spikes. A spike must be an aberration, meaning
the price levels should return to the defined range rapidly. In
statistics, removing the spikes from a field of values is
recognized to reflect an accurate average of “typical” values.
Including spikes distorts that field. The same applies in the use
of internal trendlines. Strict adherence to the rule of the
trendline (it begins at a clear point and ends when the slope of
the line is violated) is applicable in many situations but is also
inflexible when applied rigidly.
This exception to the trendline rule should be used only
when it clarifies the situation. In the example, ignoring the
spikes helped to recognize the movement of price over time in a
generally bullish long-term direction. This direction is clarified
by identifying the rising level of resistance (broken line on the
chart) over the entire period charted.

Validation of the Trend

Not every chart makes it possible to draw a valid trendline. You

need at least two connecting points, preferably uninterrupted by
reaction high or low price moves, to call a price move a
trendline, and more to the point, to use trendlines to spot a
trend. A trendline is simply a range of price changes shown by
the line itself, without running into an offsetting price direction.
For Bollinger Bands, the trend is defined by upper and lower
bands representing two standard deviations from the center
band; but in the trendline, which is intended to validate the
trend, the levels are defined by drawing straight lines from point
to point and without running into a reversal in price.
Three rules of validation also help in this task.
 First, the more price bottoms or tops that can be connected in
a single line, the stronger the trendline and the greater its
significance. When three or more price points are connected in a
straight line, this represents advancing support (in an uptrend)
or declining resistance (in a downtrend).
Second, the greater the duration the trendline holds, the
stronger the underlying trend.
Third, angle counts in the trendline. An unbroken steep angle
is a strong signal that a secondary trend is underway or, with
equally strong confirmation, that a new primary trend has
begun. Changes in scale and price increments will change the
appearance and degree of volatility.
The trendline exists only when the straight line can be drawn
(under a rising trend or above a falling trend), but it cannot run
into the price as price reverses. In drawing a trendline, a chartist
can decide where to begin and end, but the most accurate
versions will adhere to the rule that the line itself should be
close to the evolving price level. This enables analysis of testing
the trendline without violation.

Key Point: Trendlines are validated by the number of times its

border is tested without breakout.

Validation also applies to the number of times the trendline is

tested without price moving through. This applies to uptrends as
well as to downtrends. The stronger a trendline holds, the more
it begins to act like rising support or falling resistance. The
longer a trendline continues without price penetration, the
stronger the trend. Applied rigidly, this should exclude internal
trendlines as exceptions. Another form of validation occurs
when a trendline is violated with repeated spikes, meaning the
internal trendline is weakened by excessive spikes. When the
frequency of spikes increases, they cease to be exceptions and
the validity of the trendline must be questioned. This repetitive
pattern might also forecast a change in direction rather than just
an exception to an otherwise consistent trendline.
When the trendline is less than clear, due perhaps to
excessive spikes, one of the best confirmation tests is to include
volume with the test of the trendline. If spikes are far apart and
accompanied by volume spikes, but price returns to the level
within the established trendline, it confirms its validity.
However, when price persists in violating the trendline, it could
mean that a reversal is underway when volume spikes recur just
as often. Price gaps make this a near certainty.

Retracement versus Reversal

Retracement is a short-term price adjustment against the

prevailing trend. The small change in price direction signifies
nothing permanent, and retracement often works as a form of
continuation signal.
There are several ways to distinguish retracements form
reversals. First, they are very short term, and price quickly
resumes the prevailing trend. It is likely to test resistance or
support without success. Finally, retracement tends to occur
with little or no reversal signal. A reversal, in comparison, is
forecast when a clear signal occurs and is confirmed.
Flags and pennants are found at moments of retracement
and represent price continuation. As short-term signals with
sideways movement, these signals are useful for short-term
price movement, notably retracement. A flag is a rectangular
movement set up with resistance at the top and support at the
bottom. A pennant is a triangle with a narrowing range
culminating in top and bottom very close together in breadth.
 The pattern of flags and pennants appears in a direction
opposite the prevailing trend, and then just as quickly, the
pattern resumes. Although the concept of consolidation applies,
some flags and pennants occur in patterns moving first in one
direction and then in the other. In that sense, they may retrace a
prior retracement, which is confusing and a signal of short-term
volatility.
Flags are parallel rectangular lines moving sharply away
from the trend and may occur in rapid succession when the
trend is undergoing a consolidation pattern. For example, Figure
4.9 reveals an extended consolidation pattern of two years after
conclusion of a bullish trend, characterized by a series of flags.

Figure 4.9: Flags

Source: Chart courtesy of StockCharts.com

The initial bullish trend moved from $25 to $34 over a period of
seven months, after which the consolidation began and
continued for the next two and a half years. During this time,
price ranged back and forth between $29 and $36, with
retracement marked by a high volume of flags, retracing swing
trends in both directions. Between May and December 2014, a
set of upward price patterns retraced over and over, and price
was not able to penetrate resistance.

Key Point: Flags (rectangles) and pennants (triangles) are short-

term patterns characterizing retracement patterns.

Pennants play a similar role to flags in retracement patterns,

setting up symmetrical triangles of very short duration moving
sideways or opposite the swing trend immediately preceding it.
The chart in Figure 4.10 provides an example of this short-term
retracement pattern.

Figure 4.10: Pennants

Source: Chart courtesy of StockCharts.com

The symmetrical shape of pennants adds uncertainty to the

current trend. This chart revealed an uptrend during most of
2012; however, the two years from 2013 to 2014 contained a
narrow range moving sideways with strong support at $32.50
per share. The pennants appeared at, or immediately after, price
made a very short-duration strong move. The pennants held
price within the narrow range setting up an unusually long
consolidation for this stock.
 Flags and pennants often are associated with strong dynamic
trends. When the trend is moving, the flag or pennant works as
a retracement. However, as the chart in Figure 4.10 reveals,
these may also appear in long-term consolidation patterns.

Fibonacci Retracement

In identifying trendlines, retracement presents a problem. If

short term, the retracement may be explained away with
identification of flags or pennants and reaction high and low
spikes can be ignored with the use of internal trendlines.
However, longer-term retracement—lasting between one and
three months—presents greater difficulty. It may easily be
misidentified as a swing trend or even as a secondary trend due
to its duration.
One method for tracking these price patterns against the
prevailing trend is with Fibonacci retracement analysis.
Leonardo Fibonacci (1170–1250) was a mathematician who
developed an observation of numerical patterns that came to be
called the Fibonacci sequence. The sequence consists of the sum
of the two preceding numbers in the count:

0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, etc.

By itself, this is nothing more than a predictable mathematical

sequence. However, upon further examination of the properties
in this sequence, it can be used to make accurate predictions
about statistical trends and, especially, about retracement. For
example:
1. Any number in the sequence, divided by the previous
number, equals approximately 1.618. This value, 1.618, is
 called the Golden Ratio and is found in art, biology,
architecture, and nature.
2. Any number divided by the number that follows, equals
approximately 0.618.
3. Any number in the sequence, divided by the value two
places higher, equals approximately .382. Referring to the
previous calculation, it is also true that 1 – 0.618 = .382.
4. Any number in the sequence divided by the value three
places higher, equals approximately .236.

These values or percentages often appear as the level of

retracement after a price move. If a price moves several points
and then retraces, it often will move in the opposite direction by
62 percent, 38 percent or 24 percent (rounding the outcomes
above) of the initial price move.
For example, Figure 4.11 provides a chart with examples of
retracement between one and three months.

Figure 4.11: Fibonacci retracement

Source: Chart courtesy of StockCharts.com

The first instance is a move from $49 up to $60.25, or 11.25

points. It then declines to $56, or 4.25 points. When the
retracement of 4.25 points is divided by the original move of
11.25 points, the result rounds up to 38 percent:

4.25 ÷ 11.25 = 37.7%

The second instance begins at $56 and rises to $64, or 8.00

points. It then declines to $59, a drop of 5 points. When the
retracement of 5 points is divided by the original move of 8
points, the result rounds down to 62:

5 ÷ 8 = 62.5%

The third instance begins at the price of $59 and rises to $69, or
10 points. It then declines to $62.50, a drop of 6.5 points. When
the retracement of 6.5 is divided by the original price move of
10, the result is 65, close to 62:

6.5 ÷ 10 = 65%

These examples demonstrate a tendency for retracement greater

than a few days to closely match the relationships of the
Fibonacci sequence. At the time of analysis, it is difficult to
decide where the retracement will conclude, and in some cases
it will turn out to move more or less than one of the sequence
values. A problem with this mathematical calculation of
retracement is that by selecting the beginning and ending price
levels, these may become self-fulfilling prophecies. It is difficult
to rely on Fibonacci retracement to time trades with consistency
and accuracy.
As a method for managing the trend (but not necessarily for
timing trades), the Fibonacci sequence is a worthwhile indicator.
In the chart, the overall three-year trend clearly is bullish, rising
from $42 up to nearly $70 over three years with consistency—
even though the periods of retracement are substantial and
have durations that could represent secondary trades or even
reversal of the primary trend itself.

Key Point: Fibonacci retracement is useful for predicting a

degree of price moves, but its usefulness is also limited.

One of the flaws in using Fibonacci retracement is that, with

three possible markers, not to mention an additional 50 percent
possible retracement also recognized as a significant price point,
it is easy to make a case for the Fibonacci sequence as a certain
indicator. In practice, it is difficult to spot in the moment of the
retracement, and it serves as only one possible tool among many
for identifying the condition of a current trend.

Channel Line Types

While trendlines mark rising support in a rising breadth of

trading and falling resistance in a falling breadth, channel lines
further define a dynamic trend. When a trend moves in a bullish
or bearish manner but maintains its breadth of trading, it is
exceptional. The controlled volatility of such a move adds
strength to the trend; it also provides a method for identifying
when the trend is leveling out or likely to reverse.
The channel lines consist of two parallel lines drawn above
resistance and below support. The narrower the breadth and the
longer the channel persists, the stronger the trend. Like
trendlines, both channel lines are drawn at low and high points
and are connected. For example, Figure 4.12 shows a rising
channel lines formation lasting eighteen months. The breadth of
trading was 15 points from high to low throughout this
timeframe.

Figure 4.12: Rising channel

Source: Chart courtesy of StockCharts.com

The end of this uptrend was clearly marked at the beginning of

February 2014 when the price declined sharply lower and broke
through the lower channel (support). Even though price rallied
back into the established range, the trend was over. Price began
declining once again after a gap at the beginning of August and
continued downward until mid-December.
In this formation, the trend was apparent, and an analyst
could assume with confidence that it would continue until a
clear reversal signal emerged. The breakout below the lower
channel was precisely this type of signal. Upon confirmation of
the reversal from other signals, it was the time to adopt a
bearish posture on this stock. The gap at the beginning of August
2014 was a compelling signal that warned of further declines,
notably since very few visible gaps were found throughout the
three-year period.
A falling channel provides the same assurance in the
opposite direction. Duration varies in all trends, but the channel
lines provide a clear signal of prices trending in one direction
for as long as the channel holds. An example of falling channel
lines is seen in Figure 4.13.

Figure 4.13: Falling channel

Source: Chart courtesy of StockCharts.com

This chart shows two distinct bearish channels with volatile

price patterns in between. Prices first moved sideways and then
trended upward strongly, but quickly resumed the downtrend.
In the first falling channel, which lasted nine months from the
beginning of the period charted, the breadth of trading was
about 5 points. Some isolated spikes broke through on either
side but did not persist beyond single sessions. The second
channel lines were also 5 points in breadth and lasted
approximately ten months.

Key Point: Channel lines may be drawn even with price moves
violating the lines if those are only spikes and price retreats inside
the channel.

In the first example, the downtrend ended with a bullish turn

above the falling resistance marked by the upper channel.
However, the second channel ended with further price decline
below the falling level of support. A second interpretation of this
falling channel would be to mark support three points lower
and call it an 8-point breadth. This lower channel is stronger
since it involves no breakouts; however, the starting point is not
a precise low-price level. Even so, this demonstrates that
channel lines can be manipulated to aid in visualizing a trend
and in spotting potential reversal points.
A flat channel example is shown in Figure 4.14. This chart
contains two instances with a very brief upward price
movement in between.

Figure 4.14: Flat channel

Source: Chart courtesy of StockCharts.com

The first consolidation pattern had a breadth of trading of just

over 30 points and lasted for the entire year of 2012. The next
three months trended upward, and the remaining period of over
two and a half years revealed a duration of approximately 45
points. The price bounced back and forth between resistance
and support during both flat channel periods, making this an
excellent candidate for swing trading activity. For long-term
analysis, more information would be required to determine the
next direction for price.
Channels are more than just merely interesting formations.
They are useful for identifying emerging overbought or oversold
conditions that point to forecast of reversal within the channel,
which are pullbacks within the longer-term trend. They also
may be tracked to identify likely points at which primary trends
are ending and likely to reverse. Figure 4.12 provides an
example of this in which a long-term bullish channel ended
decisively, after which a downtrend followed. An investor with a
long position in that company might have identified the
violation of the lower channel line as the first signal that the
trend was over and sell long positions to take profits.

Key Point: Channel lines often highlight overbought or oversold

conditions for in-channel price patterns.

A normal formation of channel lines is expected to eventually

lead to reversal and channel lines are among the easiest to spot,
since a clear violation of one of the two lines is easily detected.
When the breakout is in the direction the channel lines are
moving already, it could mean an expanded and accelerated
trend, or it could forecast a reversal in the opposite direction.
This would be the case if specific reversal signals were present,
such as double tops or bottoms, head and shoulders; one of the
many candlestick reversal patterns; volume spikes or indicators;
moving average crossover; or momentum oscillators entering
overbought or oversold condition.

Expanding with the t-line

The trend can be tracked with considerable accuracy when
using Bollinger Bands in conjunction with the t-line. This signal
is represented by an eight-day exponential moving average
(EMA). Most online charting services allow you to set up
automatic EMAs of any duration. Placing the t-line on a chart
along with Bollinger Bands is simple.
The t-line is based on a premise that crossover marks a
change in trend direction. When the t-line is below price and
crosses above, closing above for two days, it is a bullish reversal
signal. When the t-line is above price and crosses below to close
below for two days, it is a bearish signal.
As far as it goes, the t-line is a tracking average, and is
interesting but not entirely reliable. However, when it is added
to Bollinger Bands as indicators on the chart, the combined
signals become exceptionally reliable. On most charts, the t-line
will appear as a solid line and of a color different than the three
Bollinger Bands. An uptrend consists of the upper Bollinger
bands serving as resistance and the t-line as support. A
downtrend consists of the t-line as declining resistance and the
lower Bollinger Bands as support.
These two signals operating together tend to set up very
narrow channels. Once price moves above a declining channel,
it strongly indicates a bullish reversal. And once price moves
below an advancing channel, it is an equally strong indication of
a bearish reversal. For example, Figure 4.15 provides three
examples of downtrends and reversals.
 Figure 4.15: T-line with Bollinger Bands
Source: Chart courtesy of StockCharts.com

In each case, the narrow channel is easily seen. The first lasted
two weeks, the second one month, and the third two weeks. In
each case, the t-line marked declining resistance and the lower
band was declining support. In each case, the downtrend
concluded when price moved above the t-line and closed there
for two days. Price behavior in September and October
foreshadowed the strong bullish trend that began in November
and moved price 16 points to the upside.
Some traders use a technique called t-line scalping. In this
strategy, the t-line is combined with a twenty-day simply moving
average. A position is opened once price establishes itself either
above (bullish) or below (bearish) the t-line for two closes. The
channel is defined in a way like that used for the more reliable
Bollinger Bands method; however, this form of scalping is
redundant since the middle band of Bollinger is a twenty-day
moving average; the comparative indicator exists. However,
basing the channel on the relationship between t-line and upper
or lower bands (which are developed using standard deviation),
provides a superior signal. The method using Bollinger Bands
may be considered a form of t-line scalping but with more
reliable signals.
The t-line, like many indicators, is weak by itself and does not
provide certainty about the change in trend direction. Most
charts contain many false starts based on the t-line. As a result,
most analysts give the t-line little attention. However, when
placed on the chart with Bollinger Bands, it adds exceptional
predictive benefits and highlights reversals effectively.
This applies most accurately in swing trades, which is where
traders are most likely to enter or exit positions. This is where
the value is found in the t-line and Bollinger combination. One
of the more challenging tasks for the analyst is distinguishing
between swing trend reversals and secondary or primary trend
reversals. The question of reversal identification for trends is
the topic of the next chapter.

Endnotes
1 Friesen, Geoffrey C., Paul A. Weller, and Lee M. Dunham. “Price Trends and Patterns
in Technical Analysis: A Theoretical and Empirical Examination.” Journal of Banking
and Finance, 33, issue 6 (June 2009): 1089–100.
2 Lawrence, Ramon. “Using Neural Networks to Forecast Stock Market Prices.”
University of Manitoba, Department of Computer Science (December 1997), p. 5.
Chapter 5
Reversal Patterns: End of the Trend
The confirmation of primary trends in the Dow Jones Industrial
Average (DJIA), obtained by tracking other Dow Jones indexes, is
far from clear. A turn in price is controversial, and there is no
universal agreement about whether a reversal is a secondary
trend or a new primary trend. The same problem is found in
tracking individual stocks. When does a primary trend end and
how do you spot it?
This is the core problem of trend analysis. A reversal may
represent a new direction for the stock for coming months or
years. It may also be a secondary trend, with the primary trend
in effect for the longer term. It could be a swing trend that will
last only a few days, or merely a retracement.

Key Point: A reversal can have numerous interpretations.

Therefore, trend analysis depends on insight and strong
confirmation.

This chapter explores many different types of reversals and

their attributes and provides a starting point for identification of
what price patterns mean in the larger context of the trend. It
explains many of the configurations of Western or Eastern
reversals and explores some of the more reliable and frequently
occurring signals. While swing traders can focus on the very
short-term signal and its confirmation, how do investors apply
reversal indicators to spot primary and secondary trend
activity? The answer may be found not only in single or double
signals, but in the occurrence of numerous signals in the same
timeframe.

This chapter explains many of the most frequently seen

reversals:
– Head and shoulders
– Inverse head and shoulders
– Gaps
– Rounding top and bottom
– Rectangle top and bottom
– Double top and bottom
– Diamond formation
– Long white and black candlesticks
– Dragonfly doji
– Gravestone doji
– Hammer and hanging man
– Inverted hammer
– Engulfing pattern
– Harami and harami cross
– Doji star
– Piercing lines
– Meeting lines
– Three white soldiers and three black crows
– Morning and evening stars
– Abandoned baby
– Squeeze alert

The Dilemma: Minor or Major Reversal

Investors tracking prices on charts have many tools available for

determining whether a trend is continuing or growing weaker.
For example, the use of trendlines and channel lines, Bollinger
Bands and other statistical tests, and observations of price in
proximity to resistance and support, all help to spot a trend’s
longer-term health and strength.
Once the price activity diverts from an orderly and identified
trend, it is likely to signal a coming change. That may be
represented by a period of consolidation or outright change in a
trend’s direction. Trendlines and channel lines track the
direction and duration of the trend and set up a disciplined and
predictable course—until it all changes. Once the trendlines are
stopped or channel lines break down, it is time to consider the
possibility that the trend is about to conclude. One of the most
significant changes occurs not only when price violates the
rising or falling breadth established by channel lines, but also
when the breadth of trading expands rapidly. A broadening
breadth of trading, the visualization of growing volatility, signals
the potential for the struggle between buyers and sellers to
exhaust the current trend.
When resistance or support lines are broken, price behavior
also provides insight. As discussed earlier, one of the strongest
signals of a new direction in the trend is the flip of resistance to
support (on the upside) or from support to resistance (on the
downside). This flip sets up exceptionally strong new borders to
the trading range even with higher volatility. Price behavior at
or through these lines signals a high likelihood of a change in
the trend’s direction.

Key Point: The flip between resistance and support is a

compelling signal that also adds strength to a revised trading
range.
Price gaps occurring at resistance or support are strong signals
of reversal, if only to the extent that price will return to the
previously defined trading range. However, price gaps may also
occur when the trend is accelerating to higher momentum or
when reversal will take place not only into range, but through
the range and in the other direction. Resistance and support are
the price points where longer-term trends are most likely to face
challenges and where reversal is at its most likely point. This
proximity is worth noting. Most reversals will be strongest when
they occur at resistance or support, especially if price has
gapped through those trading range borders. Proximity marks
the most likely timing and placement of reversal. Signals,
confirmed with Bollinger Bands, added candlesticks, double tops
or bottoms, or many other signals, add to confidence that
reversal is more likely than average.

Reversal versus Consolidation

Observing that reversal is somewhat predictable based on the

broader markets, where a starting point in analysis can be
developed. Many stocks follow the index-based market
represented by the DJIA, S&P 500, and NASDAQ, for example.
Stock reversal should take into account the condition of the
market.
Even so, it is not safe to assume that a specific stock is
undergoing reversal merely because the overall market appears
to be doing so. The interpretation of index movement is flawed
for many reasons, including the distortions that index
calculations cause. Due to weighting of stocks in the DJIA, for
example, three companies (Boeing, UnitedHealth Group, 3M)
account for more than 21 percent of the DJIA movement (as of
January 2019). This makes it difficult to apply index-based mood
of the market to any one stock, with consistent reliability.1
Clearly, if a majority of stocks are down for a day or a week,
the short list of positive-moving stocks should be noted. It means
that either those are exceptionally strong companies, or that it is
just a matter of how the average work out—some stocks rise and
some fall. Market behavior has so many variables that it is not
easy to estimate where individual stocks or averages are going
to move next. This becomes more difficult considering that
reversal and retracement might look the same when they first
appear.
Accurate interpretation is a constant challenge in
distinguishing between a reversal and retracement. When a
trend comes to an end, it may reverse with immediate speed,
turn out to be only a retracement or swing trend, or may move
into a period of consolidation. This sideways-moving period of
consolidation may not be short term but could last a year or
longer.
During consolidation, it is most difficult to interpret price
activity due to the lack of indicators. Without a dynamic trend in
effect, there is nothing to reverse in terms of price direction; a
reversal signal cannot be called in the same way as during
bullish or bearish movements. Resistance and support are likely
to be flat, perhaps for an extended period, meaning that no
breakouts occur; or if they do, interpreting their meaning in
terms of a possible trend is quite difficult. In periods of
consolidation, investors are forced into a wait-and-see period if
only because the price levels are range-bound. You must look for
signals of a true breakout and establishment of a new trend. At
some point, either buyers or sellers will emerge in control, and
recognizing this moment is key to also recognizing the start of a
new trend. However, in recognizing consolidation as one form
of trend, a trend reversal (versus a price reversal) is possible,
with consolidation reversing into either bullish or bearish
movement.
When a pattern emerges that looks like reversal and does not
follow through but pauses and contradicts what the indicators
forecast, it might turn out to be a consolidation rather than
immediate reversal. In virtually any reversal pattern it is an
error to expect immediate price movement. Although immediate
movement frequently does occur, it is not a certainty. Relying on
weak indicators, or those with more than one interpretation,
also adds to the uncertainty of how price acts during what
appears to be a reversal. In traditional Western technical
analysis, a symmetrical triangle, for example, may be bullish or
bearish making it of dubious value in confirming reversal. In
candlestick analysis, a long-legged doji or spinning top also are
unclear in their meaning. They may be bullish or bearish
depending on (a) where they appear in a trend and (b) other
signals and what they forecast.

Key Point: Response to a reversal signal is not always immediate.

Even with strong confirmation, a delay is not uncommon.

An example of an apparently strong reversal signal and

confirmation that did not lead to actual reversal is seen in Figur
e 5.1.
 Figure 5.1: Delayed reversal response
Source: Chart courtesy of StockCharts.com

At the beginning of this chart, the stock price was ranging

between $8 and $11 per share. However, during the preceding
year, the price had been as high as $17 per share. A downtrend
had occurred prior to the period shown. The downward-moving
gap accompanied by a volume spike marked what could be
interpreted as a point of reversal. Once the price held strongly at
just below $8 per share, even when tested between May and
August 2012, it would have been reasonable to expect a bullish
reversal. However, the price moved into a consolidation pattern
that lasted eighteen months. Only in December 2013 did the
price break out above resistance and move higher. The breakout
was confirmed a month later in January 2014 with a strong
volume spike. The bull trend moved rapidly higher to more than
$17 per share, doubling share value in less than one year.
This chart provides an example of a delayed reaction for an
extended period of consolidation. In this example, eighteen
months passed before the forecast reversal occurred. This
demonstrates that an immediate reaction after a reversal signal
does not always occur as expected, or may not occur at all.

The Time Element: Momentum of Reversal

Another question investors must ask is what to expect after a

long period of consolidation. Will the eventual reversal be
strong or weak? How long will a new trend last?
A desirable answer would be that the characteristics of
consolidation dictate the size, shape, and duration of the trend
that does follow. Unfortunately, that is not the case. However,
momentum is expressed in the deferred reversal, eventually. In
the case of the chart in Figure 5.1, the exceptionally long
consolidation led to a strong uptrend. To some degree, this
range-bound period might have influenced the new trend and
might have gathered a high number of interested buyers.
However, even in hindsight it is impossible to quantify the role
of consolidation in the strength of the new trend.
In analyzing dynamic (bullish or bearish) trends, the
momentum of an original trend is most likely to affect the
momentum of a reversal. However, in consolidation, because
price is limited to a small trading range, it has no momentum
until a breakout occurs and a new, dynamic trends begins. For
this reason, the pattern and duration of consolidation cannot be
judged in terms of how it affects the new trend that follows.
Some consolidation leads to bullish trends, others to bearish
trends. A third group replaces one trading range of momentum
with a higher or lower range of momentum.
Investors must rely on the reversal itself to judge not only
when a trend will begin but how strongly it will behave. For
example, referring once again to Figure 5.1, there are some clues
anticipating the breakout in December 2013. First was the spike
in late October, occurring as price bounced off the low in what
could be considered the final line of a W bottom. This forecast a
rise; however, several previous signals appearing like W bottom
formations occurred during consolidation. Like many examples
of range-bound price movement, there were no clear signals
anticipating the successful bullish move. This was a case of
hindsight rather than of forecasting insight.

Reversal in Western Patterns

In periods of consolidation, just like all moments in a stock

chart, you must rely on the strength of reversal signals and
confirmation from secondary signals. The Western technical
signals used by so many traders can be used by long-term
investors as well. However, knowing which signals are
applicable to swing trends and which are applicable to primary
or secondary trends, is a considerable challenge. You need to
rely on how compelling a set of signals is before deciding that a
primary or secondary trend is reversing. The likely reversal
points often depend on proximity to resistance and support, the
points where reversal is most likely.

Key Point: Reversal can occur at any point in the current trend,
although at resistance or support the chances of successful
reversal are far greater.

Head and Shoulders

One of the best known reversal patterns is the head and

shoulders. The concept in this pattern is that it tests resistance
and, upon failing to break through successfully, price will then
retreat in the opposite direction. The bottom of the three
attempted breakouts is called the neckline, which serves as a
form of interim support. Once price moves below the neckline,
the bearish formation of the head and shoulders is confirmed
and the price is likely to continue falling.
For example, in Figure 5.2, two examples of head and
shoulders were revealed, both with clear neckline price levels
and both followed by a price decline. The first of the two head
and shoulders formations spanned two months and the second
spanned four months. Some head and shoulders patterns occur
quickly and are more typical of bearish signals within swing
trends. When a pattern takes a longer time to develop, it is more
likely to present a bearish secondary trend.

Figure 5.2: Head and shoulders

Source: Chart courtesy of StockCharts.com

This chart appears to be in a long-term bullish trend from a

price around $52.50 at the beginning of 2012, up to $85 by the
end of 2014. However, in between were two secondary trends,
both marked by the head and shoulders patterns shown on the
chart. The first secondary trend lasted nine months and ended
in January 2013 and the second started near the beginning of
2014 and lasted more than ten months, ending in October before
prices began a 30-point bullish move in the last three months of
2014.

Key Point: A head and shoulders is a strong reversal signal, but it

is easily misinterpreted or over-looked.

The same pattern occurs on the opposite side on the trading

range. An inverse head and shoulders (also called a head and
shoulders bottom) takes place as a test of support and forecasts a
new bullish trend. Like all reversals, it should be confirmed by
additional patterns or indicators. Figure 5.3 shows an inverse
head and shoulders developing over six months.

Figure 5.3: Inverse head and shoulders

Source: Chart courtesy of StockCharts.com

The time required for this pattern to emerge indicates that it is

part of a primary trend reversal. The stock peaked above $43 in
March 2011 before the period shown and then declined to about
$37 per share, where a new resistance level is noted on the
chart. This also serves as the neckline for the inverse head and
shoulders. Assuming support was at about $31 per share while
this pattern emerged, the head, dipping below to $28, was a
failed breakout. When this occurs as part of the inverse head
and shoulders, a new bullish move is expected.

Key Point: An inverse head and shoulders is subject to the same

rules as its bearish counterpart, but it appears at the bottom of a
downtrend and is bullish.

In this case, the bullish move occurred and quickly rose above
the $37 neckline and resistance. Confirming the new bullish
trend and adding strength to the bullish breakout was a flip
from prior resistance to set up new support. The new support
level was tested over the next year, without any serious
breakouts. The activity throughout this chart was typical of the
inverse head and shoulders: a failed breakout below support
followed by a strong bullish rise in price breaking out above
resistance and remaining there. In this case, the new support
level held for the remainder of the period shown and held for
several months beyond.

Gaps

Another familiar formation in Western technical analysis is the

gap. This is by no means a rare pattern; gaps are found often on
stock charts and come in many forms.
First is the common gap, which offers no significance to
interpreting the price chart. One test of a common gap is to see
how quickly it gets filled (meaning price retreats to cover the
range of prices represented in the gap). It is often the case that
common gaps are filled immediately or very quickly.
A gap with greater meaning is called the breakaway gap
because it sets up a move in price outside of the established
trading range. When this occurs in a direction opposite the
prevailing trend, it could be a strong reversal signal. However,
because the price breaks through resistance or support with
gapping action, reversal is more likely than at other points in the
price pattern.
The breakaway gap may also occur within a primary trend
and may even set up an accelerating move within that trend.
This is especially true when the gap sets up a flip from
resistance to support (bullish rise) or from support to resistance
(bearish decline). An example of this price pattern is seen in Fig
ure 5.4.

Figure 5.4: Gaps

Source: Chart courtesy of StockCharts.com

The gap shown in Figure 5.4 spanned 9 points and moved

strongly above resistance. It was confirmed when the resulting
decline failed and price continued upward. Prior resistance
became new support in this case, with the trend clearly marked
by the line of resistance/support and augmented by the strong
price gap.
While this pattern is unusual, it should not be ignored. It
adds strength to an already rising trend and moves the breadth
of trading into new territory. The breadth before the gap was
approximately 4 points even as the price levels rose. After the
gap and establishment of a higher trading range, breadth of
trading fell to 2 points or less. While this could be viewed as a
sign of a weakening trend, a broadening gap would be more
troubling. In this example, even though prices were rising
dramatically throughout the chart, volatility (as measured by
breadth of trading) declined. However, the decline occurring
between December 8 and December 22 approached rising
support and anticipated a slowing down of the trend’s curve.
During the first quarter of 2015 (beyond the charted period)
price leveled out and settled in around $94 per share, a good
indicator that this primary trend could have exhausted or was
beginning to exhaust after rising 20 points over three years.
Another type is the runaway gap that is caused by growing
interest among buyers (on the upside) or sellers (on the
downside). The enthusiasm revealed in the pattern could lead to
an equally strong and even accelerated reversal. It is
characterized by a series of repetitive gaps in a short period of
time, with prices spiking upward or downward as a result.

Key Point: Gaps indicate growing interest among buyers (upside)

or sellers (downside), but also set up a volatile environment for
the trend.

The last type is called an exhaustion gap. This is found near the
end of a trend and signifies a coming reversal. It is identified by
accompanied high volume and is likely to be found at (or
moving through) resistance (in a bullish trend) or support (in a
bearish trend). Proximity to these all-important price points is a
strong signal. However, the exhaustion gap also needs
confirmation from other signals beyond the volume spike. A
change in a momentum oscillator adds convincing confirmation.
A move into over-bought territory anticipates a strong bearish
reversal and a move into oversold anticipates a strong bullish
reversal.
The combined occurrence of an exhaustion gap, a breakout
above resistance or below support, a volume spike, and a
momentum signal, provide one of the strongest combination
reversal forecasts possible.

Rounding Top and Bottom

Besides the spiking prices associated with head and shoulders

and gaps, some trends are found in a softer rounding effect. The
rounding top or bottom mark a potential reversal but without
the clear spiking price points expected in so many types of
signals.
A rounding top is most convincing as a signal of reversal
when it “rounds” higher than resistance. In such a case, you
expect to see price retreat to the downside in a new bear
market. An example is found in Figure 5.5.

Figure 5.5: Rounding top

Source: Chart courtesy of StockCharts.com
Unlike the heads and shoulders with its fast-moving and spiking
prices, the rounding top evolves in a less volatile manner. In this
example, resistance was on the rise with some considerable
volatility in the trading range. The rounded move took price
through resistance and then retreated strongly. This resembles a
double top; however, most analysts expect to see the top spikes
in more dramatic contrast to prices immediately before and
after. The decline in price following the rounding pattern was
confirmed by the accelerated movement as well as the
downward-moving gap in mid-April.

Key Point: Rounding tops and bottoms are like spikes but
without the accent on one or two sessions.

A rounding bottom has similar tendencies for less volatile

contrast between prior prices and the turn in the trend. Figure 5.
6 shows a rounding bottom formation.

Figure 5.6: Rounding bottom

Source: Chart courtesy of StockCharts.com

This stock had traded as high as $65 per share the year before,
so this chart began near the conclusion of a strong downtrend.
The spike in the middle of the rounding activity tested support
and failed, and after this price began trending upward in a new
primary trend lasting at least to September 2014, a span of two
years.
The price gap in October 2012 marked the beginning of the
new uptrend, quickly followed by an initial climb of more than
20 points between November 2012 and February 2013, only
three months.

Rectangle Top and Bottom

A similar pattern is found in the rectangle top and bottom

patterns. These are high or low trading ranges marked by ranges
of price rather than by specific price points. The rectangle may
also be marked by price gaps on both sides or by strong price
moves.
An example of a rectangle top is shown in Figure 5.7. Note
the similarities in these formations. In the first, the beginning
and ending points were marked by gaps; in the second, prices
moved steeply before and after the rectangle.

Figure 5.7: Rectangle top

Source: Chart courtesy of StockCharts.com
The rectangles could be treated as marking resistance on their
top, in which case the double top formed in May and August
2013 represent failed breakouts. However, if the assumption is
that resistance was more likely at $165, the rectangles are failed
breakouts on either side on the double tops.

Key Point: Rectangle formations are yet another form of reversal

signal, but they consist of a range of sessions rather than on one
or two session spikes.

A rectangle bottom presents the same interesting interpretive

data. In Figure 5.8, a rectangle bottom precedes a strong bullish
trend.

Figure 5.8: Rectangle bottom

Source: Chart courtesy of StockCharts.com

In this instance, the first rectangle lasted for ten months and the
second for four months. These are by no means short-term
reversal signals; they are more likely to be breakouts below
support forming secondary trends against a primary bullish
trend. That primary trend began at the very beginning of the
chart, when price was beneath $27. The three-year trend moved
price to over $40 before retreating by the end of the period
charted.
In this interpretation, support would reside at about $29.70,
marked by the broken line on the chart. Both rectangle bottom
formations were secondary trends or, rather, secondary
consolidation periods. They did not move upward or downward
but remained range-bound until the final breakout in mid-
November marked by the price gap. What followed was a
resumption of the previous primary uptrend.

Double Top and Bottom

The next formation is one often found, cited, and relied upon to
spot reversals. The double top and double bottom are a set of
price spikes near one another. When these are found at or close
to resistance (double tops) or support (double bottoms), the
likelihood of reversal is high.
However, the definition of “close proximity” is far from clear.
The two spikes might be found in consecutive sessions or they
might be a month apart. Proximity is a relative term. When
looking at a one-month chart, a spike near the beginning and
another near the end could hardly be thought to be related.
However, when looking at a three-year chart, the one-month
separation is not as exclusionary. In this case, the two spikes are
clearly associated, assuming that (a) they are in proximity to
resistance or support or better yet, move through those
boundaries; (b) price retreats immediately and begins moving in
the opposite direction; and (c) price does not eventually succeed
in breaking out but returns into range or sets up a trend in the
opposite direction.
Key Point: Double tops and bottoms occur often, but when found
at or near resistance or support, they indicate a strong chance for
reversal.

An example of the double top is found in Figure 5.9. All the

requirements for a double top were met.

Figure 5.9: Double top

Source: Chart courtesy of StockCharts.com

The resistance on this chart is identified at approximately $43

per share. This is based on price holding there except for the two
double top movements. The first set was separated by one
month and the second by less than one week. However, once the
resistance line is drawn, the significance of the failed double
tops becomes clear. The double tops in this example moved
through resistance, retreated immediately, and did not
eventually return to break through.
In some cases, double tops or bottoms do not require two sets
to confirm the failed breakout. The formation on its own is a
strong one, and if confirmed by other price patterns, volume
spikes, or momentum oscillators, can demonstrate a strong
reversal and establishment of a new trend. For example, the
chart in Figure 5.10 provides a look at a double bottom that
leads immediately to the expected bullish reversal and the
establishment of a new primary trend. This new trend lasted at
least two and a half years until the end of the period charted.

Figure 5.10: Double bottom Source: Chart courtesy of StockCharts.com

In this case, the definition of “close proximity” again comes into

play. The two bottom spikes were nearly two months apart and
yet they marked the bottom of the downtrend and began the
beginning of a new primary bullish trend. If this were a three-
month chart, the two spikes would not be acknowledged as
relating to one another. So, “close” proximity is a relative term.
This proximity issue also demonstrates that shorter-term charts
may not be especially effective for recognizing long-term trends
and when or where they reverse direction.
Expanding on double tops and bottoms is the stronger
version—triple top or bottom—consisting of three spiking price
sessions at the top of a trend (signaling bearish reversal) or at
the bottom of a trend (signaling bullish reversal).

Diamond Formations
In some reversals located at proximity to resistance or support,
the rounding, double, or rectangle formations form a diamond
shape. The resulting diamond formation is noticeable by its V-
shaped neckline. An example is shown in Figure 5.11, with
necklines marked with a broken line. The diamond tends to
appear at or near reversals of primary trends, just as these do,
both for bottom and top diamond formations.

Figure 5.11: Diamond formation

Source: Chart courtesy of StockCharts.com

The diamond tends to take time to fully develop. The example

includes a diamond bottom spanning five months and a
diamond top over four months. In between was a primary
bullish trend spanning nearly two full years. The uptrend was
volatile with price gaps before and after a large price decline of
one month and a series of runaway gaps ending with a large
price spike. Both bottom and top also could be interpreted as
symmetrical triangles. These may be bullish or bearish
depending on where they appear. In this case, the diamond
formation, like the symmetrical triangle, appeared at the end of
each trend, strongly forecasting reversal. A problem with this
observation is that it is clear in hindsight, but at the time it
forms the meaning is not as obvious.

Key Point: Diamond formations are variations on the rectangle

and may occur often. However, their meaning depends on where
they are found.

Triangles and wedges (both described in Chapter 3) may provide

false signals and often are so close to one another that in shape
that they can be confusing. The ascending triangle and falling
wedge are considered bullish and both descending triangle and
rising wedge are bearish. Because both triangles and wedges
form when there is a narrowing breadth of trading, they can
have contrary meaning more often than most signals. A
diamond should be treated as part of the price pattern for
reversal of a primary trend while triangles and wedges might be
viewed with greater caution.

Reversal in Eastern Patterns

In addition to the many Western reversal signals, Eastern signals

(candlesticks) also signal reversal. Like the Western patterns,
candlesticks have the strongest predictive power when
appearing at resistance or support and after particularly strong
trends:
Analysis based on candlestick patterns enhances an
investor’s ability to prepare for trend changes. Being familiar
with the psychology behind specific candle formations provides
immense advantages. Candle signals can identify a trend
reversal in one day. More often, the Candlestick signals can
forewarn when a trend is preparing to change.2
 The art of candlestick analysis is not complex but it does
involve analysis of dozens of different candlesticks, both
reversal and continuation patterns. Some indicators are
stronger than others, so it also pays to be aware of a short list of
signals offering the most value as signals and confirmation for
reversal.

Key Point: Strong candlesticks support likely reversal with

exceptional reliability. However, not all candlestick indicators are
strong; some only provide a 50 percent chance of success. Thus,
using only candlesticks with higher success rates makes sense.

The reversal signal, whether Western or Eastern, works for all

types of trends. Swing traders may time their trades based on
candlesticks and other indicators and improve their
effectiveness in generating profits. For longer-term trends,
candlestick signals work with other price and volume indicators
to warn investors about weakening trends or outright reversal
about to occur. No system provides 100 percent confidence, but
combining candlestick analysis with other forms of technical
analysis improves your awareness of the trend and its status.

Long Candles

One of the most recognizable of all candlestick signals is the

single-session long candle. This is a session with a larger than
average distance between opening and closing. The candlestick
consists of a rectangle, which is called the real body. The bottom
of the white candlestick’s real body is the opening price for that
session, the top is the closing price. This is an upward-moving
day. On a black candlestick (a downward-moving day), the
opening price is the top horizontal line and the closing price is
the bottom.
The color distinctions make a chart easier to read, and
finding long candlesticks is easy because they stick out.
However, “long” is a relative term. A chart with 1-point scaling
could report a long day with a 3-point move versus typical
moves under .5 point. For a chart scaled in 10-point increments,
“long” would have to consist of many more points. A long
session compares a typical length of a day’s breadth to
exceptionally expanded breadth and not to a fixed number of
points.

Key Point: A long candlestick refers to breadth between opening

and closing price; however, depending on scaling, the number of
points is not as important as the session’s breadth compared to
other sessions before and after.

A long white session is bullish and a long black is bearish. When

these appear in proximity to support (white) or resistance
(black), they work as reversal signals. Assuming confirmation is
located at the same time; the long candlestick is a strong and
easily recognized signal. For example, Figure 5.12 provides clear
examples of how long candlesticks appear at crucial points in
trends and their reversals.
 Figure 5.12: Long candlesticks
Source: Chart courtesy of StockCharts.com

The support level on this chart is difficult to determine because

the overall trend appears to be bearish but the low levels of
trading are extremely short in nature. Both support and
resistance are set for limited times with volatile change in
between. So even with a primary trend gradually declining,
secondary trends or swing trends appear to take place over a
matter of only a few months. One is found in the last two weeks
of August, another in the second half of October, and a final one
in the second half of December.
In the last two swing trends the beginning of reversal was
marked by long white candlesticks. These long sessions are
remarkable due to their breadth. As resistance declines over the
six months of this chart from a high of $44.50 down to the
ending price of $42, support is less identifiable. The price range
is not great but the interim volatility makes this stock a good
candidate for swing trading. The key element of the short-term
reversal is the long white candlestick. A more detailed analysis
of the candlestick indicators on this chart reveals many
confirming signals; and adding in volume and momentum
signals further clarifies the strength and duration of the swing
trends. The “anchor” to the turn in direction is the long white
candle session.
The long black candlestick session holds the same level of
importance, notably when it appears at the top of an uptrend
and approaches or violates resistance. In both cases, when a
long candlestick appears in the wrong place (white during an
uptrend or black during a downtrend) it does not represent a
signal of any importance. Some candlestick analysts have made
a case for treating reversal candlesticks as continuation signals
when they appear in the wrong proximity; however, this is
questionable as a signal of value. A confirmation signal should
appear near a breakout above resistance or below support. Long
candlesticks are easy to understand and to spot. They indicate
movement in the direction of the candle (white is bullish, black
is bearish). Finding these at the proper proximity in a trend
provides a good starting point for identifying reversal for trends
of all types.

Doji Formations

The long candlestick is easily spotted merely due to its size. A

more difficult session to spot is the doji, Japanese term that
means “mistake.” This is a session with little or no real body
resulting from opening and closing price being at the same level.
Instead of a rectangular real body, the doji reveals only a
horizontal line.

Key Point: A doji consists of opening and closing prices at about

the same price, forming a horizontal line in place of a rectangular
real body.
The doji comes in several variations. Among these are the
bullish dragonfly, the bearish gravestone, and the long-legged
doji and spinning top (both either bullish or bearish depending
on the context in which the session is located). These are all
summarized in Figure 5.13.

Figure 5.13: Doji types

Source: Prepared by the author

The long shadows on dragonfly and gravestone reveal why they

are bullish or bearish. The shadow reveals the extent of trading
range during a session beyond opening and closing prices. On
the dragonfly, selling activity is expected to move far below the
opening price, but sellers might not be able to move the price
lower, returning it to the opening level by the close. The
gravestone is the opposite; buying activity is represented in the
long upper shadow, but buyers might not be able to maintain a
higher price and the session would retreat to the opening level
by the close. These long shadows reveal weakness in the
direction they occur.
On both the long-legged and spinning top sessions,
significance relies on where it is found. Either of these found at
support or resistance can add to a likelihood of reversal if other
reversal signals are also present. The lack of any open-to-close
range on the long-legged doji and the very small range on the
spinning top are only half of the meaning in these signals. The
upper and lower shadows reveal a struggle for control between
buyers and sellers. Ultimately, the winner is revealed in the
direction that price ends up moving. Therefore, as a confirming
signal for reversal, when these are found at (or moving through)
resistance or support, they are compelling signals of coming
reversal. By themselves, these are not strong enough to enter a
trade, but with other reversal signals they provide good
confirmation.

Hammer and Hanging Man

Among single-session candlesticks, the hammer and hanging

man are unusual. They have the same attributes and formation
but are diametrically opposed signals depending on where they
appear. This signal consists of a small real body and a lower
shadow that extends farther than the range of the real body. The
real body may be either white or black.
When this appears at the top of an uptrend, it signals a
reversal to the downside and is called a hanging man. When it
appears at the bottom of a downtrend, it signals a reversal to the
upside and is called a hammer. As with all indicators, these
should also be independently confirmed by other candlesticks,
Western signals, volume, moving averages, or momentum
oscillators. They also apply in all types of trends: swing,
secondary, or primary. An example of the hammer and hanging
man is shown in Figure 5.14.
 Figure 5.14: Hammer and hanging man
Source: Chart courtesy of StockCharts.com

In the hanging man, the second occurrence confirms the first

and immediately results in a one-month downtrend. The
hammer appeared at the bottom of the next downtrend and led
to a two-month uptrend.

Key Point: Hammers and hanging man sessions have the same
features and may have real body that is either white or black.
They are found at resistance or support and strongly forecast
reversal.

A closely related signal is the inverted hammer. Although called

a hammer like the bullish variety, the inverted hammer may be
bullish or bearish. The bullish version is shown in Figure 5.15.
 Figure 5.15: Inverted hammer
Source: Chart courtesy of StockCharts.com

Inversion of signals adds confusion to the pattern. Unlike the

“regular” hammer, the inverted hammer requires two sessions.
In the bullish version, like the one shown in the chart, a black
session is followed by a downward gap and then an inverted
hammer. It contains a small real body of either color and an
upper shadow. This forecasts a reversal and uptrend.
In the bearish version of the inverted hammer, a white
session is followed by an upside gap and then a hammer session
containing a small real body of either color and an upper
shadow at least the height of the real body, often more. The
longer the upper shadow, the stronger the indicated reversal.

Engulfing Pattern

Among two-session indicators, the engulfing pattern is one of

the strongest. It is found often in charts and when confirmed is a
valuable and strong reversal signal. The bullish version consists
of a black session followed by a longer white session. The real
body of the second session extends both higher and lower than
the preceding black session (engulfing it). An example of the
bullish engulfing pattern is shown in Figure 5.16.

Figure 5.16: Engulfing pattern

Source: Chart courtesy of StockCharts.com

Price gaps strongly upward right after the engulfing appears.

This sets up a strong rally that returns price into the previously
established range. An estimate of support throughout the chart
is at $73.50. If this is recognized as true support, the four
sessions dipping below that level culminate with the bullish
engulfing and create a failed breakout below support.

Key Point: The engulfing pattern occurs often and is among the
strongest of reversal candlesticks. It should be located at
proximity to resistance (bearish) or support (bullish).

A bearish engulfing pattern contains a white session and

immediately after a larger black session. With both types, the
shorter the first session and the longer the second, the stronger
the signal. In the bullish version shown in the chart in Figure 5.1
6, the engulfing was exceptionally strong and led to a strong and
rapid rebound. All patterns can fail, but when the size and shape
of sessions within a pattern are minimal, failure is more likely.
So a two-day engulfing that barely meets the pattern
requirement will not be as strong as one with stronger contrast
from day one to day two. An engulfing pattern with sessions
close in size, appearing after a weak trend, is likely to either fail
outright or lead to a slow or minimal reversal.
When a strong engulfing pattern is found at the top of an
uptrend or at the bottom of a downtrend, reversal is very likely.
This is especially true when the pattern is right at the borders of
the trading range or moves through it. In the chart shown in Fig
ure 5.16, the bullish engulfing appeared after price violated
support. This is the most likely timing for reversal, and the
engulfing is one of the strongest of reversal signals; the bullish
response was not surprising.

Harami and Harami Cross

The opposite of the engulfing is the harami pattern. In Japanese,

harami means “pregnant.” This is not as strong as the engulfing
as a reversal, but when found in the right proximity and
confirmed by other signals, it provides reliable confirmation of
the reversal forecast.
A bullish harami consists of a black session followed by a
smaller white session. The first session is higher and lower in
range than the white session, creating the shape of the typical
harami.
A bearish harami is the opposite. It is a white session
followed by a smaller black session. It should appear at the top
of an uptrend to work as part of a forecast for bearish reversal.

Key Point: A harami is opposite in design from the engulfing. It

also signals reversal but is not as strong as the engulfing pattern.
The harami cross is like the harami, but the second session
forms a “cross” shape, representing a doji session. The bullish
harami cross consists of a black session followed by the doji
(cross), and the bearish harami contains a white session
followed by the doji.
An example of the bullish harami and the bearish harami
cross is found in the chart in Figure 5.17.

Figure 5.17: Harami pattern

Source: Chart courtesy of StockCharts.com

The bullish harami appeared right at the bottom of a three and a

half-month downtrend, marking the end of the trend and
coming reversal. A month later, the bearish harami cross
forecast a downtrend, which came only after a three-week delay.
As with many signals, reversal did not occur immediately after
the appearance of a price pattern indicator.
The harami and harami cross often are found at the right
proximity to create or confirm reversal. A bullish signal is likely
to be found after a downtrend and a bearish signal after an
uptrend. When these appear elsewhere within a trend, they
should not be considered as having any special meaning. For
reversal to be valid, there must be a trend to reverse.
Doji Star

Another two-session reversal signal is the doji-star. The bullish

version starts out with a black session, then a downside gap, and
a doji. This should be located at the bottom of a downtrend and,
when confirmed, signals a coming reversal and uptrend.

Key Point: The doji star consists of two sessions separated by a

gap in between. It is a strong reversal indicator due to the gap.

The bearish version starts out with a white session, then an

upside gap, and a doji. Look for this reversal signal at the top of
an uptrend, which signals reversal and a new downtrend. Both
varieties of this signal are highlighted in Figure 5.18.

Figure 5.18: Doji star

Source: Chart courtesy of StockCharts.com

The chart in Figure 5.18 tested support twice before rising from
a low under $80 to an ending high at about $96. The bullish doji
star foretold the bottom of the downtrend; and the bearish doji
star near the end of the chart signaled a coming downtrend.
However, the following period continued the consolidation
pattern that started in late November. This one was difficult to
call since no compelling long-term trend appeared to be in
effect. The previous period, from 2012 through 2014, was a
primary bull market, with the price moving from $45 to $95. The
period following, the start of 2015, could be a pause for
consolidation with renewed bullish movement starting in
February 2015.

Piercing and Meeting Lines

The next set of patterns is found often in charts. The piercing

lines and meeting lines are useful reversal signals, but they
should be confirmed before deciding to act.
The bullish piercing lines begin with a black session and then
a white session. The white session gaps lower to open below the
prior close and then closes within the range of the previous
day’s real body. The bearish version opens with a white session,
gaps to open higher with the second day declining to close
within the range of the first day’s real body.
The chart in Figure 5.19 contains examples of both bullish
and bearish piercing lines.

Figure 5.19: Piercing lines

Source: Chart courtesy of StockCharts.com
These are interesting patterns. The occurrence of two sets of
each of these provides initial reversal forecast and then
confirmation. The bullish example tests support and predictably
leads to an uptrend. The two bearish piercing lines exceed the
rising line of resistance and then decline rapidly to test support
once again before returning to an uptrend. Overall, the chart
appears to represent a long-term primary bull trend starting out
in the mid-50 range and climbing above $60 per share six
months later.

Key Point: Piercing and meeting lines are found often on price
charts but should be confirmed before trades are entered.

The meeting lines signal is similar with an important exception.

The second session closes at the same price as the close of the
first session. In a bullish version, a black session is followed by a
downward gap and the second session opens and rises to close
at the same level. In the bearish meeting lines, a white session
closes, gaps higher, and is followed by a black session falling to
close at the same price. Both are shown in the chart at Figure 5.2
0.
 Figure 5.20: Meeting lines
Source: Chart courtesy of StockCharts.com

This pattern contains an important gap. It is invisible with a

quick glance, but comparing the first day’s close to the second
day’s open reveals the price gap. The significant aspect to this
pattern is that both days close at the same price, but the
direction changes. In the example, the bullish meeting lines
comes at the end of a very short-term downtrend and then
marks the point where the price rises. The bearish meeting lines
did not lead to a downtrend and could represent a failed signal.
In fact, the price remained at approximately the same level
through February 2015 beyond the period shown.

Three White Soldiers and Three Black Crows

Clarity of signals is a great advantage in candlestick analysis.

Among these are two three-day candlestick signals, the three
white soldiers and three black crows. Although the patterns are
not easily found in strict adherence to the pattern requirements,
they are powerful reversals when they do occur in the proper
proximity.
Key Point: Three white soldiers is an exceptionally strong bullish
reversal signal and useful when located close to support after a
strong downtrend.

The proximity for three white soldiers is at the very bottom of a

downtrend or shortly after the reversal has begun (in which
case the pattern confirms the change in direction). For three
black crows, the correct proximity is at the very top of an
uptrend or shortly after price has begun to turn downward.
Both are reversal indicators. Some analysts claim that when
these are found in the wrong proximity for reversal they are
continuation signals. However, this is not necessarily the case.
When these occur during a trend (three white soldiers during an
uptrend or three black crows during a downtrend), they are
simply coincidences and provide no actionable information.
The three white soldiers is highlighted in the chart in Figure
5.21.

Figure 5.21: Three white soldiers

Source: Chart courtesy of StockCharts.com

This signal appears immediately after the strong month-long

downtrend concluded and turned. Because the downtrend
lasted for one month, it probably should be interpreted as a
secondary trend. Clearly, it moved below support, which was at
about $20.50 per share, with that price set at the beginning of
August. After the uptrend was underway after mid-October, this
support level was tested only on a single session with a long
lower shadow, and the breakout failed. The long-term primary
trend for this stock was bullish, with the price below $11 at the
start of 2011 it was volatile, but had rising prices since that
point.
A strict set of attributes for three white soldiers is that over a
three-day period, each session must open within the range of the
previous session and close higher. Thus, the overlap from day-
to-day is essential. The example in the figure meets these
criteria, but just barely. The closing prices of each session and
the opening prices of the following session are very close
together. The longer each white candlestick and the more clearly
the session opens within the previous range, the stronger the
indicator. However, even though this example is minimal in
meeting the “rules” of the indicator, it did work as expected,
confirming the uptrend and moving price back above support.
In fact, price passed above the support line during the middle of
these three sessions.

Key Point: Three black crows should be found close to the top of
an uptrend and signals the end of that trend and reversal to a
downtrend.

The three black crows is the bearish counterpart to three white

soldiers. It should appear at the top of an uptrend and mark a
clear downside reversal. The pattern consists of three
consecutive days, with each day opening within the range of the
previous day and closing lower. Ideally, it should be found right
at resistance and is exceptionally strong if it moves price
through resistance and then retreats into range.
An example of an exceptionally strong three black crows is
seen in the chart at Figure 5.22. The long upper shadow on the
third of three days indicated failed buying activity and the long
candlestick in day two gave a strong bearish indication.

Figure 5.22: Three black crows

Source: Chart courtesy of StockCharts.com

In observing that these two patterns are difficult to find, a

clarification should be made. Many close patterns are seen on
numerous charts, but these do not strictly adhere to the
requirements of three white soldiers or three black crows. For
example, on the chart in Figure 5.21 (three white soldiers), a
pattern emerged at the price peak in mid-September. Three
consecutive black sessions were in the right proximity to
identify reversal but not every one of these sessions opened
within the trading range of the previous range. It was close, but
it was not a three black crows. This is called three identical
crows, referencing the closing price of one session and identical
or nearly identical opening price of the next session.
 In Figure 5.22 (three black crows), bullish patterns appear
several times at the end of August (but not in good proximity to
call it a reversal); at the beginning of October (again lacking
downtrend to reverse and appearing more as a series of
runaway gaps lacking the overlap required for three white
soldiers); and at the beginning of November (also lacking a
downtrend to reverse and failing the overlapping opening test).
It is fair to say that many close patterns appear on charts, but
strict criteria for both is more difficult to find. The strength in
these patterns comes from the overlap created with higher open
and close (three white soldiers) and lower open and close (three
black crows), along with the overlapping price movement.
A closely related pattern, identical three crows, also involves
three consecutive black sessions. However, instead of each
session opening within the range of the previous session, each
opening price is identical or close to the previous day’s closing
price. This is a rare pattern and a stronger one than the more
commonly found three black crows.

Morning and Evening Star

Additional three-day patterns that are found frequently are the

bullish morning star and the bearish evening star. When found
at the end of the trend, these are compelling indicators strongly
identifying the point of reversal.
The morning star has three consecutive sessions. First is a
black candlestick, followed by a downside gap, a white session,
and then an upside gap, and finally a white session. The
combination of reversed direction and gaps in between each
session makes the morning star an exceptional reversal signal.
An example, containing two morning stars near one another, is
shown in Figure 5.23.
 Figure 5.23: Morning star
Source: Chart courtesy of StockCharts.com

Key Point: The morning and evening stars are exceptionally

strong reversal indicators due to the double gaps occurring in
between sessions.

The patterns appear at the end of a six-week downtrend and

were followed by a new six-week uptrend. This back-and-forth
pattern of trading indicates offsetting secondary trends in a
long-term primary trend. At the beginning of 2011 the stock was
trading at $28, and after the period shown, by the end of
February 2015, the price had risen to $44 per share.
The evening star is bearish and consists of a white session
followed by an upside gap, a black session and a downside gap,
and a final black session. This marks the beginning of a bearish
reversal. Figure 5.24 provides an example. A very small uptrend
of two weeks culminated in an evening star, after which price
declined for the remainder of the charted period. Even though
the uptrend was minimal and was a swing trend, the turn
confirmed the weakness in the longer-term primary trend for
this company. The large upside gap of mid-September took price
well above resistance, so a retreat was expected. The two-week
rally prior to the evening star failed to deliver a bullish rally, so
the evening star confirmed the bearish signal from a month
before.

Figure 5.24: Evening star

Source: Chart courtesy of StockCharts.com

Abandoned Baby

A variation of the morning star and evening star is the pattern

called the abandoned baby. The difference is that the middle
session is a doji or near-doji. This is the “abandoned” session, so
called due to the price gaps on either side.
The bullish version begins with a black session and is
followed by a downside gap and then the doji session. Next is an
upside gap and a white session. When this pattern is at
proximity to support, it marks the bullish turning point and the
longer the last white session, the stronger the signal. The chart
in Figure 5.25 includes an exceptionally strong signal consisting
of the long white candle in the third day; this was further
confirmed by an even longer long white session seven trading
days later.
Key Point: The imaginatively named abandoned baby, like
morning and evening stars, contains gaps between sessions and
a reversal of direction.

Figure 5.25: Abandoned baby (bullish)

Source: Chart courtesy of StockCharts.com

However, even with the strongly bullish abandoned baby and

confirming long white session, the stock’s price moved into a
consolidation pattern. The next step was unclear as of the end of
2014. However, between the bottom on October 27 and the high
price in the first week of November, the price moved rapidly
from $38 up to nearly $50 per share.
A bearish abandoned baby is like the evening star but with a
doji in the middle session in place of a white or black
candlestick. Figure 5.26 contains two examples of a bearish
abandoned baby.
 Figure 5.26: Abandoned baby (bearish)
Source: Chart courtesy of StockCharts.com

This stock was volatile through the period, with a high

frequency of gaps in both directions. However, the bearish
abandoned baby signals clearly marked the tops of short-term
uptrends and resulting sharp downtrends. The first example
was exceptionally strong with a price gap of more than a point
before retreating from the high. Marking resistance at the point
immediately after this bearish signal, it rose to $12.50. Even with
this short-term volatility, the price range was only two points.
And the stock was in a long-term primary bull trend. In June
2011, it traded at $6 per share before doubling in value by the
end of the last half of 2014.

Squeeze Alert

Another interesting pattern among the many candlestick

reversals is the squeeze alert. This is yet another unusual
pattern in which a set of black candlesticks provides a bullish
signal and a set of white candlesticks is bearish.
The bullish squeeze alert consists of three sessions, each one
opening and closing within the range of the previous session.
Thus, each day’s range shrinks to smaller size in both opening
and closing price. The first and third session are black and the
middle session’s color does not matter. The ideal squeeze alert is
found at the bottom of a downtrend.

Key Point: Squeeze alerts are rare. They involve three sessions,
all with declining real bodies sized within the range of the
previous day.

An example is shown in Figure 5.27. In this case, the squeeze

alert is not the initial reversal signal, but does confirm a bullish
engulfing pattern found two months earlier.

Figure 5.27: Squeeze alert (bullish)

Source: Chart courtesy of StockCharts.com

The rising line of support augments the strength of the bullish

engulfing, occurring under support, and immediately leading
price back into range. However, price then moves into a narrow-
range period of consolidation. It appeared at first that the trend
was over, but the squeeze alert confirmed the bullish indication
and the bullish trend resumed.
 The bearish squeeze alert contains a first and third white
session with the middle session of either color. Figure 5.28
includes a pattern with a squeeze alert. Although proximity is
unusual here, it does meet the standard and confirms a primary
bear trend in this stock.

Figure 5.28: Squeeze alert (bearish)

Source: Chart courtesy of StockCharts.com

The downward price movement began in late July with a very

unusual set of signals. The long white candle looked bullish but
failed. After a set of four narrow-range days, price fell sharply
and continued moving downward for the next two months.
Once price began to rally in late September, it appeared that a
new bullish move was underway. However, the squeeze alert
provided a warning that the bears were still in control. After a
short rally up to $56, the price resumed its downward
movement through the remainder of the period charted.
All candlesticks are forecasts of how patterns are likely to
evolve, but they are far from certain. As the examples in this
chapter have demonstrated, the reversals signaled by
candlesticks must be viewed in a larger context. Many of the
charts reflected continuation of long-term primary trends or
marked secondary trend movement within primary trends. Any
reversal must be confirmed by other signals, however, because
every type of signal is likely to fail some of the time.

Divergence and its Role in Reversal Trends

Every chart watcher and analyst contends with the problem of

quantifying reversal. Is a strong signal a new primary trend, a
secondary move, a swing trend, or only a retracement? The
answer relies on taking a view of the longer-term chart and
estimating where the current price activity fits. For example,
when you find a consistent primary trend, a short-term
secondary trend is normal and expected but it does not signal a
new primary trend. For that, you need a preponderance of
signals, multiple indicators all pointing to weakness in the
current trend and the emergence of an opposite movement.
Within this analysis fundamentals should play a role as well.
A three-year technical trend is directly affected by changes in
longer-term fundamental trends. So growing strength or
evolving weakness in a ten-year study, for example, would be
expected to play out in price. Tracking revenues and earnings,
dividend yield, P/E ratio, and debt/equity ratio over the ten-year
period may reveal changes, often dramatic in nature.
Weakening earnings, even considering growing revenues,
dramatically increasing size and range of the P/E ratio, failure of
dividend yield to keep up with earnings, or growing debt ratio
are negative fundamental signs. And strong revenue and
earnings trends with steady net return, stable and moderate P/E
ratio, dividends per share increasing each year, and level or
falling long-term debt are all strong and positive signals that
also will be reflected in price.
Key Point: Any instances of divergence must be analyzed closely.
These moments may present stronger than average reversal
indicators or just a conflict of signals.

A study of the long-term fundamental trends is instructive in

determining whether current price trends are primary or
secondary and where the long-term price prospects are likely to
move. The two disciplines—fundamental and technical—are not
separate but different symptoms of the same long-term growth
or decline of a company and its stock price. The advantage for
the technical side is that demerging fundamental trends are
likely to precede a change in the price trend, so as the
fundamentals strengthen or weaken, it becomes more reliable to
quantify the current trend in perspective and with
fundamentals in mind.
As part of the dynamics between fundamental and technical
trends, divergence is a strong indicator of trend health.
Divergence is the movement in one indicator opposite what is
forecast in another. This often is seen between price and
momentum. Price continues to rise while upward momentum
weakens and warns of overbought conditions; or price falls even
as momentum reports the stock is oversold. Finding cases of
divergence cannot be restricted to price patterns alone. For
example, a strong bullish engulfing pattern is in the right
proximity to forecast reversal, but the stock price continues to
decline. This failure of the signal may be traced to a lack of
confirmation, but is also represents divergence—the signal was
bullish but price declined. It reveals the possibility that selling
momentum was stronger than the price prediction in the
reversal indicator.
Divergence can be analyzed in the context of the predictable
course of reversals. These begin with a trade set-up in the form
of price tops or bottoms, gaps, and candlestick indicators. The
timing of trades is very difficult to call precisely becoming a
problem for swing traders, and less so for long-term investors
who need only to estimate the set-up range. For example, a
resistance or support zone that is clearly identified provides an
adequate set-up for most investors with permanent portfolios.
Trying to time profit-taking as a primary trend peaks or trying to
time entry as a bargain-priced stock approaches the bottom, is
not as critical for investors as it is for swing traders.

In timing reversal trades, several attributes are desirable to

increase success. These are:
1. A long duration in the trend. Statistically, the longer a trend
continues moving in the same direction, the more likely it is
to reverse. This is an observation made in a vacuum,
however, because duration alone is not a signal that the
trend is ending. A stock with primary trends running
typically between one and two years can experience a four-
year trend, and a stable stock with typically long-term
primary trends can enter a volatile period of secondary
trends very difficult to judge. So long duration of a trend is a
positive signal due to a related tendency. As trends continue
for a long time, they tend to become low in volatility. A
sudden increase in breadth of trading, strong reversal
signals of multiple types, and a leveling out in the slope of
the trend, all anticipate a trend reversal. When the
fundamentals have changed over time, this confirms the
likelihood (but not the certainty) of the current trend
coming to an end soon.
2. Lack of confirmation for reversal signals. When a reversal
signal appears but is not confirmed by other reversal
signals, it should be analyzed with great caution. Comparing
 price to volume, moving averages, and momentum is critical
to proceed with confidence. A reversal signal by itself
should provide enough confidence to assume it is valid.
3. Divergence signals, especially between price and volume.
Investors expect price and volume to act in a coordinated
manner. So as price trends accelerate, you expect to see
higher daily volume of trading. When the price moves
suddenly but volume remains low, this is divergence of the
kind that should not be ignored. It probably means the price
move is an aberration and is likely to settle down into the
established range. It could be a speculative jump in price in
either direction caused by rumor or earnings concerns.
4. Changes in trendlines or channel lines. The trendline and
channel lines are elegant indicators because they are
simple, and they present a case clearly. You track trends
with the trendline and you track breadth of trading in the
channel lines. No matter how long the trend continues,
when price moves against the trendline or expands beyond
the channel lines, this is a first signal that the trend is
changing. That could mean reversal or expansion, and a
study of specific signals must be undertaken to determine
which type of change is likely to occur. Changes in prices
should not be ignored either. Even within an established
trading range, when a series of very low-breadth days
begins expanding, or when higher-breadth days narrow into
very small breadth, these changes signal a likelihood of
coming changes in the trend.
5. Sudden changes in price patterns. The trend reversal
becomes most likely in the final step of a reversal. This
occurs with a sudden increase in price pattern (breadth of
trading or violation of resistance or support), volume, or
momentum. These changes reveal that the current trend is
 about to reverse. There are no guarantees, but these sudden
expressions of volatility should be taken as a signal of a
likely reversal about to occur.

Key Point: Effective reversal analysis should include signals

derived not only from price but also from volume and
momentum.

Reversal analysis is far from an exact science. The analysis of

these signals over time and expressed in price, volume, and
momentum, improve timing but do not provide any guarantees.
The generalizations about signs of reversal are just that,
generalizations. Even so, in hindsight, many investors have
realized that in missing a reversal, the signs were there in
enough time to make a move to open or close a trade and
maximize profits.

Breakouts and Proximity to Resistance or Support

Perhaps the strongest signal of reversal, especially for swing

trends, is the breakout above resistance or below support. If this
occurs with strong gapping action through the border, reversal
is more likely in this location than anywhere else within the
trading range.
This observation dominates timing used by swing traders.
The observance of resistance and support is the key to timing of
trades with reversal in mind. If continuation signals do not
counteract this observed phenomenon (breakout with gaps),
reversal is highly probable. However, what does it mean for
managers of long-term or permanent portfolios?
The activity of moving in and out of equity positions often is
contrary to the goal of a buy-and-hold strategy. If value
investments with strong dividend yield and exceptional
fundamental growth are the core of the portfolio, does a
breakout above resistance indicate it is time to sell? Does a
breakout below support indicate it is time to increase holdings?
For the longer-term perspective on portfolio management, it
is likely that reaction will be minimal or that action will be taken
only if the signals are there to reveal a change in the primary
trend. However, even the most conservative investor can
mitigate risk and even take advantage of short-term reversal
with the use of conservative options strategies. These include
three strategies, although many additional strategies may also
serve the same purpose. The primary strategies to reduce risk in
expected reversal patterns or to exploit those patterns with
added income are:
1. Insurance puts are put options that place a cap on the
maximum loss possible. Buying one put per every 100 shares
of stock limits the loss to the net of the put’s strike price less
the cost to buy it. For example, buying a 50 put for 3 ($300)
caps the maximum loss at $47 per share ($50 – 3 = $47). If the
stock priced declined to $48, the loss on the insurance put
would be $21 ($48 – $47 = $1 per share). But if the stock price
declined to $44 per share, the insurance put enables the
trader to sell at a profit or exercise the put. Selling the put
when price of the underlying was at $44 represents a 6-point
profit ($50 – $44 = $6), adjusted for the cost of the put of 3 ($6
– $3 = net profit of $3). Exercising the put enables the trader
to sell shares for $50 per share, creating the same outcome of
6 points profit in the stock, minus 3 points for the original
cost of the put. But even if the stock continued to decline, the
maximum loss is frozen by the insurance put.
Insurance puts can be purchased when the stock’s value
has moved higher than expected and when you do not want
 to sell shares, but you are concerned about a loss in the event
of a strong price reversal. Looking at the cost of the put as the
price paid for insurance is an effective form of risk
management.
2. Collars are the combination of a short call and a long put,
opened with one of each option per 100 shares in the
portfolio. The cost of the put is offset by the income from the
call. This expands the insurance put by exchanging the cap
on maximum loss with an offsetting cap on maximum gain.
The short call’s premium limits the maximum profit to:

Call strike(+) − net premium − original basis

For example, you buy stock at $35 and it currently is valued

at $48, a difference of $13 per share. You open a collar,
paying $300 for a 47.50-strike put and getting $325 for a 50-
strike call, both after trading costs. If the call is exercised, the
stock is called away at $50, so the net profit on 100 shares is:

$5, 000 + $25 − $3, 500 = $1, 525

The collar limits potential profit on the upside in exchange for

limiting maximum loss on the downside. If the share price falls
below the put’s strike of 47.50, shares can be sold for $47.50 per
share no matter how low the price of shares declines.
3. Covered calls are popular with traders. One call is sold for
every 100 shares owed. If the call’s strike is higher than
original basis in shares, a profit is derived from the combined
capital gain, dividend yield and option premium. The
covered call also reduces net basis in stock by the call’s
 premium. For example, if you buy shares at $42 per share
and sell a 45 call for a premium of 3 ($300), your net basis is
reduced to $39 per share.

Conclusion

Reversal is at the heart of most technical analysis. Chartists seek

early signals that price is about to turn in the opposite direction.
The strength or weakness of a confirmation signal determines
whether the initial reversal succeeds or fails. The next chapter
deals with the meaning of confirmation signals and how they
influence the current trend.

Endnotes
1 IndexArb, “Index Component Weights of Stocks in the Dow Jones Industrial
Average,” at http://indexarb.com/indexComponentWtsDJ.html
2 Bigelow, Stephen W. Profitable Candlestick Trading. Hoboken, NJ: John Wiley & Sons,
2011, p. 21.
Chapter 6
Continuation Patterns: A Bend in the Trend
Trend analysis consists of observing an unending series of
reversals and continuations. Some analysts pay little heed to
continuation, however. The perception is that continuation only
tells you to do nothing, so there is little point in tracking it.
However, continuation is much more than just a reminder to do
nothing.
Chapter 5 focused on reversals, the signals appearing that
forecast a change in price direction. This chapter presents a
different range of signals. Continuation signals forecast that the
current trend is going to continue. Just as reversal must be
confirmed, continuation signals are only reliable when two or
more appear together.

This chapter explains many of the most frequently seen

continuation patterns, and has two sections:
Section 1, continuation following reversal
– Head and shoulders
– Inverse head and shoulders
– Gaps
– Rounding tops and bottoms
– Rectangle tops and bottoms
– Double tops and bottoms
– Flags and pennants

Section 2, continuation signal types

– Cup and handle
– Long candlesticks
– Long-legged doji
– Spinning top
– Thrusting lines
– Separating lines
– Side-by-side lines
– Tasuki gap
– Gap filled

Section 1 demonstrates how continuation appears after a

reversal signal. Section 2 introduces continuation signals
expected to appear within an established trend.
Many books on the topic of technical analysis pay little or no
attention to continuation signals.
Other books associate continuation patterns with
consolidation (see Chapter 8), periods in which price pauses
and moves sideways until it finally breaks out into a new trend.
Most sources define continuation as occurring during a pause
in the current trend. This does occur on occasion; however,
continuation is more likely to be found during a strong bullish
or bearish trend and provides investors with guidance about
the strength and duration of that trend. The prevailing focus on
reversals overlooks many of the key elements of trend analysis,
including identification of whether the current trend is likely to
keep moving in the same direction or is beginning to weaken
over time.

Key Point: Continuation and consolidation are not the same

thing. Continuation is a signal about the trend; consolidation is a
type of trend with prices moving sideways.
When a stock in your portfolio is undergoing a bull trend,
continuation reminds you that your holdings are properly kept
in place. However, it could also tell you to increase your
holdings with the idea that prices are likely to rise. Out of
respect for the standards of diversification as a practice to
manage risk, it would not make sense to put too much capital
into one issue, even when strong confirmation is found.
When a stock’s current trend is falling, investors will decide
to get out at some point. Hopefully, the point will be at the
beginning of the downtrend and not at the end. If a long equity
position has been closed, when should you move back in?
Waiting for the downtrend to bottom out, it is easy to miss the
reversal and see it only after it has begun. However,
continuation signals allow you to monitor the downtrend
looking for the bottom. Once these signals stop and prices begin
to level out or bullish reversals start to appear, it probably
means the timing is good to take up a new long position. Part of
that decision is the result to tracking continuation and looking
for it to end.
For those investors taking up short positions in stock (or in
their options), continuation of a downtrend has an entirely
different meaning. Once in a short stock position, the more
decline the stock undergoes, the more profit the short seller
earns. Tracking must involve watching out for reversal, to time
that all-important buy to close the order. For those selling call
options, the same cautionary practice involves riding the
downtrend until it bottoms out and, unless the short call
expires worthless (creating a 100 percent profit in the short
call), it becomes apparent when the downtrend has leveled out
or begun to turn. At that point, the short option trader will want
to buy to close and take profits. The opposite applies to put
sellers, whose advantage accrues during an uptrend. The
farther away from the put’s strike, the less value there is in the
put and the greater the eventual profits.
Continuation is not limited to the narrowly focused idea that
no action is required or that the trend is safe. One element of
the continuation signal is found soon after a reversal. For
example, a trend stops and a new one begins. Will it continue or
fail? Will it move beyond resistance or support? At the
beginning of a new trend, after reversal of the previous trend,
these questions are not easily answered. At such times, clear
and specific continuation signals are reassuring because they
forecast that the new trend is likely to succeed, even if it moves
beyond previously set trading borders.
For all investors and traders, continuation is more than a
call to inaction. It is a tracking mechanism that advises you
about the state of the trend. And once the activity of
continuation changes, it signals a new reaction for timing of
trades.

Key Point: Continuation is not a lack of trend but a specific type

of trend that ultimately signals change and a new direction.

A related problem investors face is also corrected using strong

continuation signals. It is easy for investors who are succeeding
in timing of trades to become overconfident and to develop
biases based on their success. This attrition theory means that
investors place emphasis on outcomes confirming their actions,
while tending to ignore outcomes contradicting their
perceptions, assigning such negative outcomes to “external
noise.”1
This problem is addressed by observation of continuation
signals. When an investor has become vulnerable to the bias
growing from past successes, an effective method for holding
that bias in check is to recognize continuation not based on
belief alone but through the location of continuation signals.
This chapter explores many of the reversal patterns
introduced in Chapter 5 but examines them in greater detail,
seeking examples of confirmation for these or for prior patterns
that these reversal signals confirm.

Continuation and its Relationship to Reversal

Every trend reversal should be confirmed in two ways. First,

you need confirmation of the actual reversal before acting.
Entering or exiting a trade without confirmation of the reversal
is a mistake. This is the immediate form of confirmation and it
might relate to a swing trade or even a very short-term
retracement. The second form of confirmation is found in what
happens to price in the next phase. Confirmation increases
confidence in what the original signal predicted. The next
question—after the reversal has occurred—is whether the new
trend will continue or reverse yet again.
Once the reversal has occurred will it continue or is it a false
indicator? To proceed with confidence, the new direction must
be confirmed as well. This will be found in price moves above
resistance or below support, moves beyond an identified
neckline (in head and shoulders patterns, for example), or in
specific continuation patterns identified through candlestick
signals.
Traditional technical analysis focuses on reversals through
head and shoulders, price gaps, double tops or bottoms, and
moves related to resistance and support. Few indicators are
specifically identified as continuation signals. These are limited
to flags and pennants often associated with retracement or with
price uncertainty in a short-term period of indecision or with
the small list of other technical signals. An advantage to
candlestick signals is that many relate specifically to
continuation. With candlesticks, continuation patterns—
especially when found near resistance or support—can add
confidence to a decision to continue tracking the current trend,
even when price moves beyond those all-important breadth
borders. Just as reversal is most likely at resistance or support,
continuation with a breakout is also most likely if those specific
continuation signals are present.
Some candlestick analysts claim that a reversal signal may
also work as continuation if located in the wrong place. When a
reversal occurs during a trend, but indicating the direction is
already underway, the argument is that this constitutes
continuation. However, this is a questionable assumption.
When a reversal pattern appears, but there is no trend to
reverse, it is a non-signal. Assuming strength in the trend based
on a misplaced reversal signal and then assigning it the
properties of continuation, is misleading and confusing. An
indicator should be thought of as either reversal or
continuation but not as both.

Key Point: Candlestick signals are either reversal or

continuation. When they appear in the wrong proximity they are
not valid signals.

In addition to a signal not being valid due to the wrong

placement, some formations are simply coincidences. Assigning
value to these is also an error. A smart procedure for
identifying reversal or continuation relies on (a) proper
proximity and (b) confirmation. You expect to see a bearish
reversal at the top of an uptrend and a bullish reversal after a
downtrend. You also expect to see specific continuation signals
that provide bullish signals in the uptrend or bearish signals in
the downtrend. Like reversal signals, continuation is strongest
when price has moved through resistance or support. If
continuation and confirmation are found together, the trend is
likely to continue and, potentially, in a new trading range
established after a breakout.

Western Continuation Signals

The possibility of continuation will be found following reversal

and may occur immediately or over the span of the new trend.
Once the reversal is complete, and price begins its new trend;
the question for every investor is whether the new trend is
going to continue.
One form of confirmation is found after the reversal signal.
Popular Western reversal indicators and the forms that
continuation and confirmation take are discussed below.

Head and Shoulders

The first signal is the popular head and shoulders, introduced

as a bearish reversal in Chapter 5. All too often, however, this
signal appears in an uncertain environment. For example, in a
bullish primary trend how do you identify a reversal attempt
and legitimate head and shoulders pattern? Some price
movements are not specific enough to conclusively call them a
swing trade and to identify whether the pattern has taken
place. The head and shoulders is among the most confusing of
patterns, because it is usually identified as reversal but at times
acts as continuation. With this in mind, the need for strong
confirmation when dealing with head and shoulders cannot be
overlooked.
In Figure 6.1, what appears to be a bullish rally moving
against the prevailing trend failed and moved below the
neckline, confirming that the brief rally had failed. Once price
fell under the neckline, it did not rise above it for the following
eighteen months.

Figure 6.1: Head and shoulders and confirmation

Source: Chart courtesy of StockCharts.com

The attempted rally was a bullish swing trend within a primary

bearish trend. It took price up approximately 4 points in a chart
with 2.5-point spacing, so the short-term move was substantial
enough to recognize it as a move against the primary trend. The
top of the move (the head) came within 2.5 points of the falling
line of resistance. However, once price fell beneath the neckline
with a fast price decline between September and November, the
prevailing downtrend was confirmed and the head and
shoulders also confirmed the primary bearish direction. As
expected in a head and shoulders, the failure to break through
resistance and the subsequent decline below the neckline
confirmed the longer-term trend.

Inverse Head and Shoulders

The opposite of the bearish head and shoulders is the bullish

inverse head and shoulders. This pattern challenges support
and, upon failure, leads to an expected bullish rally. An example
of this is seen in Figure 6.2.

Figure 6.2: Inverse head and shoulders and confirmation

Source: Chart courtesy of StockCharts.com

The price direction started out as bullish until the last four
months of 2012. Price declined beneath support as the inverse
head and shoulders formed. In the expected pattern, price rose
above support and continued its bullish primary trend.

Key Point: All reversal signals need to be confirmed to lead to

action. Some signals, even confirmed ones, simply fail some of
the time.
The trend marked by the inverse head and shoulders was
confirmed as price moved strongly above the neckline, which is
a check point for the head and shoulders and confirmation of
the failed decline. As price moved higher than the neckline, it
gapped and moved strongly, further confirming the price
direction following the inverse head and shoulders.

Gaps

A lot can be observed about gaps, and in Chapter 10 they are

studied in detail. For the moment, gaps are examined as
continuation signals for trend behavior. A gap may act either as
reversal or continuation; with this in mind, the appearance of
gaps has to be treated carefully and confirmed with other
signals. Figure 6.3 displays a strong primary bull trend with a
series of specific price patterns involving gaps.

Figure 6.3: Gaps and continuation

Source: Chart courtesy of StockCharts.com

In three instances, the strongly bullish trend gaps upward as

the price slope narrows. Does this mean the trend is coming to
an end or just settling down into a less volatile form? This is the
question investors must ask when price moves in one direction
very quickly, as it did on the chart in Figure 6.3 for the first
eighteen months. The pattern that repeats during this time—
strong gap moving price upward and then resumption of the
bullish trend—confirms the overall direction with no indication
of weakness. In this pattern, the gaps are part of the
continuation signal for the bullish primary trend.
Gaps often are troubling for chartists, however. Their
significance is not always well understood and they may easily
be perceived as signs of volatility and uncertainty rather than
as part of a continuation signal. The repetitive nature of these
gaps and resulting price movement constitute clear
continuation even during a volatile period. Price moved from
$55 to $90 during the first eighteen months (35 points) and then
moved about 20 points in the remaining eighteen months. For
trend watchers concerned with excessive volatility in a trend, a
change in direction might represent reduced volatility. A
secondary symptom is lack of significant gaps in the second half
of the chart.

Rounding Top and Bottom

The rounding patterns act much like other technical patterns

failing to move price in a specific direction. Chapter 5 described
rounding patterns as reversals, however, they may be only
coincidental price patterns unless strongly confirmed. For
example, Figure6.4 includes an example of a rounding top. But
the question remains: Can the downtrend be confirmed? In this
case, after the third rounding top price declined sharply.
 Figure 6.4: Rounding top and continuation
Source: Chart courtesy of StockCharts.com

The apparent reversal of this decline could be questioned at the

point that price fell below support. At first, it appeared to turn
again and move upward above support so that it looked like a
failed breakout at support. However, confirmation of the
reversal followed quickly with another decline below support,
and a downward moving price gap at the end of November
(further confirmed by another downward gap approximately
one week later). In this case, the repetitive rounding top pattern
led to a downtrend below support, which was confirmed once
price established its new range and gapped even lower.

Key Point: Rounding patterns are reversal signals and variations

of the double top or bottom. However, in some cases they serve
as continuation, making the signal unreliable in comparison to
more precise signals.

The rounding bottom is a bullish indicator suggesting a coming

uptrend. In Figure 6.5, an example of these patterns confirmed
a clear bullish primary trend.
 Figure 6.5: Rounding bottom and continuation
Source: Chart courtesy of StockCharts.com

The bottom pattern first appeared as price declined over a

period of one month. This could have represented the
beginning of a downtrend, however, price immediately
rebounded. A second price decline to the newly established
rising support created a second rounding bottom. A final level
of continuation was set by the third rounding bottom well
within range. A final price decline to the point of support did
not break through, establishing that the primary bull trend
would be likely to continue. The bullish trend continued
through for the following two months as this trend and
continuation predicted.

Rectangle Top and Bottom

The rectangle top and bottom often are found in a trending

pattern and can predict either a reversal or a move into
consolidation. Like the rounding top or bottom, the rectangle
pattern is not a strong or reliable signal. The chart in Figure 6.6
is typical of this price pattern.
 Figure 6.6: Rectangle top and continuation
Source: Chart courtesy of StockCharts.com

It appeared, at first, that price was trending downward, but

support declined without price breaking through. This could be
the start of a new primary bear trend or just the end of the
previous bull trend and a move to consolidation. Continuation
was not established, however, until the price spiked below
support. The fact that it did not hold reveals that the declining
rectangle tops were not the start of a bear trend but a more
likely move into a sideways consolidation pattern. The price
level did continue sideways, trading between $25 and $30 for
the following three months after the period shown on the chart.

Key Point: Is a reversal likely to lead to an opposite-moving

trend or a consolidation trend? The only way to know is by
noticing the nature of confirming signals.

A rectangle bottom is a bullish signal, most likely appearing

after a swing trend moving opposite the primary trend. An
example is shown in Figure 6.7.
 Figure 6.7: Rectangle bottom and continuation
Source: Chart courtesy of StockCharts.com

In Figure 6.7, a series of fast but short-lived downtrends

occurred within the primary bull trend over three years. The
failure of price to turn down for any length of time confirmed
the strength of the trend. The bullish rectangles were confirmed
with each subsequent rise back to resistance, and the final
move upward in February 2014 was a clear continuation
pattern for the long-term trend predicted in the series of
rectangles. In the two months following the charted period, the
stock price rose another 10 points.

Double Top and Bottom

Two of the most frequently occurring signals are double tops

and double bottoms. As reversal signals, these are reliable and
easy to spot. Even so, to establish the success of this signal, two
elements need to be present. First is the reversal itself
(preferably more than just one signal) and second is
continuation of the new direction taking place after the double
signal.
An example of the double top is shown in Figure 6.8.
 Figure 6.8: Double top and continuation
Source: Chart courtesy of StockCharts.com

The troubling aspect in this chart is that three distinct and

strong double tops appeared before price turned downward.
This brings up the possibility that the signals were not strong
enough to act upon. However, by the third double top the likely
bearish reversal was more certain. One thing occurring with
this chart was the appearance of an evolving resistance level.
During the consolidation between January 2012 and late
October 2014, resistance was firmly set at $41 or $42 per share.
Then price gapped upward and rapidly moved above $50, with
the three double tops along the way. With each double top,
price retreated immediately only to return to a new high. With
the third double top, how should this be interpreted?

Key Point: Some signals repeat several times before an expected

reversal occurs. In this situation, the repetitive signals confirm
one another.

The first two double tops appeared to set up secondary trends

of only a few months. After the third double top, the decline
taking place without stopping was a convincing move.
However, after a long period of consolidation preceding this
one-year up and down movement, it was difficult to determine
the actual direction of price. Continuation was set once the
declining resistance extended more than four months. Even
then, the overall meaning of the trend was not easy to see. With
the dip below support and immediate return above, a primary
bear trend was not likely. In fact, that support level held even
beyond the period shown; the double top formations earlier in
2014 were likely to relate only to the secondary bear trend from
July to December 2014, with a new bullish move following.
The double bottom, like the double top, often is difficult to
understand. Figure 6.9 provides an example of numerous
double bottom formations during a primary uptrend.

Figure 6.9: Double bottom and continuation

Source: Chart courtesy of StockCharts.com

In this case, the primary trend extended through the entire

three-year chart. No fewer than six secondary or swing trends
were found during this period. In each case, the downtrend did
not last long and immediately after, a short reaction ending
with the double bottom formations, price rebounded. This
repetitive pattern (downward move, double bottom,
resumption of primary trend) was a form of continuation
traders could use to predict that the established primary bull
trend would continue. The established pattern did continue, in
fact, into 2015.

Diamond Formation

A diamond may form as either a top or a bottom. It is a reversal

signal, but, like all reversals, it requires confirmation. Even
with confirmation, the next step is not always clear. Once a
reversal begins, the question is whether it’s a false move or can
be confirmed. An example is found in Figure 6.10.

Figure 6.10: Diamond formation and continuation

Source: Chart courtesy of StockCharts.com

Price moved up dramatically beyond the 2012 range-bound

trading between $39 and $45, forming a diamond top in the first
eight months of 2013. As expected, a strong reaction followed,
taking prices down to the newly established support. However,
prices then trended upward in a secondary trend forming
another diamond top. Once again, prices reacted by declining.
At this point, the validity of this reversal was in question.
However, the downtrend was confirmed with the continuation
established once price fell below support and remained there.
Following the upward curve of price, support held for the
following two months, meaning that the continuation set with
the breakout in September 2014 was a strong signal.

Key Point: Diamond signals are less distinct than many

reversals, so shape and proximity are the keys to recognizing a
true reversal.

Flags and Pennants

Previous examples of flags and pennants referred specifically to

retracement formations. However, these may also provide
short-term continuation signals within an established primary
trend. For example, in Figure 6.11, a series of flags appeared
over a two and a half-year primary bull trend. The last two in
2014 might be defined as retracements, but the first two,
dominating 2013 trading, were not.

Figure 6.11: Flags

Source: Chart courtesy of StockCharts.com
The action outlined as flags set up a secondary trend, but the
narrow range forming the flag also acted as continuation
signals for the bull trend. This is one example of a secondary
trend setting up as a continuation signal. The narrow range
reveals that short-term price channels will not last long enough
to represent a new primary trend.
Pennants also work as continuation patterns. Figure 6.12
was dominated by a long-term primary bull trend. However,
this became volatile from the second half of 2013 through the
first half of 2014. This volatility could have forecast a reversal,
but the narrowing range forming the pennants contradicted
this and provided continuation signals.

Figure 6.12: Pennants

Source: Chart courtesy of StockCharts.com

The interesting attribute of this pattern is that price fell below

the ascending support between August and October 2014. This
was not a compelling breakout, however, since the breadth
formed a narrow channel throughout this period. The strong
gap upward took price back into range, adding additional
continuation signals for the established primary trend. These
pennants did not contain attributes of retracement. The first
one moved in the trend’s direction and the second one tracked
support closely. Even so, the pattern itself was a double
continuation signal that was bolstered by the later failed
breakout below support.

Key Point: Flags and pennants are closely associated with

retracement and often are found as part of a continuation signal.

Cup and Handle

The cup and handle is a bullish continuation pattern with two

parts. The cup is a rounding bottom and the handle that follows
immediately is a flag. As a continuation signal rather than a
reversal, the cup and handle is valid only if the trend continues.
Figure 6.13 includes three examples of the continuation offered
by the cup and handle.

Figure 6.13: Cup and handle

Source: Chart courtesy of StockCharts.com

The first continuation signal occurred as the downtrend

bottomed out and began rising, forming the first cup. The
handle, a flag, took up two months and set up a continuation for
the trend that started three months before.
The second example showed up as price peaked and began
declining. At first, this appeared as a reversal or retracement,
but as it rounded it appeared to fail as a downward move. The
handle assured continuation.

Key Point: The cup and handle is a specific type of continuation

signal, but compared to other, less complex ones, it is not always
easily recognized.

The third and final example was very similar. Price peaked just
above $125 and then paused. The small cup and handle
predicted accurately that the rising support was not in any
danger. Two attempts at breakout at the end of the chart failed.
In the period after the charted three years, support continued
to hold but resistance leveled out. This formed a two-month
bullish continuation signal in the form of an ascending triangle
in the time beyond this chart, adding further to confidence in
the primary bullish trend.

Eastern Continuation Signals

The emphasis in Western signals is on reversal. And with few

exceptions, continuation relates to the continuation occurring
post-reversal, as the previous section demonstrated. With
Eastern indicators (candlesticks), the distinction is more
defined. Candlesticks are either reversal or continuation
indicators. When continuation is located at or close to
resistance or support, it has great significance. Proximity is one
of the factors adding strength to a continuation signal. If price
breaks out above resistance or below support and at the same
time, a continuation signal appears, you seek confirmation in
one or more forms.
This may be found in a second candlestick indicator, a
Western technical indicator, volume, moving average, or
momentum oscillators. Also, strongly confirming continuation
is the activity related to proximity itself. For example, a flip
from resistance to support or from support to resistance tends
to strengthen the new trend.

In observing the behavior of price, additional generalizations

can be made:
1. A strong trend (meaning a combination of momentum,
slope, and duration) tends to lead to strong continuation
signals at resistance or support and to strong confirmation.
2. The resulting continuation of the trend tends to be strong
as well, notably when resistance flips to support (bearish)
or when support flips to resistance (bullish).
3. A weak trend (short duration, narrow slope, slow moving)
tends to offer little if any continuation signaling, and if
these do appear they also tend to be marginal (barely
meeting the signal criteria, for example). Confirmation may
be marginal as well or even nonexistent.
4. A weak trend and weak continuation is vulnerable to
failure or may move into consolidation rather than
continuing as predicted. This often creates a period of
uncertainty and a narrow breadth of trading.

An analysis of the popular continuation candlestick patterns

demonstrates that these generalizations can serve as guidelines
for the timing of trades.
Long Candlesticks

Long candlesticks were previously introduced and explained as

part of reversal. The length of the candlestick does not refer to a
specific number of points because scaling is not the same for
every chart. Rather, a “long” candlestick must be defined as a
session that is exceptionally long in comparison to typical
sessions before and after.

Key Point: A “long” candlestick is a relative signal. Due to

dissimilar scaling of charts, it is defined as long compared to
other signals close by and not based on the number of points of
price movement.

The long candlestick may be either a reversal or a continuation

signal. As a continuation signal, the proximity of the long
candlestick is crucial to its power. For example, in Figure 6.14
two long candlesticks were located, the first marking the point
of reversal and the second providing continuation in
conjunction with a newly established level of rising support.

Figure 6.14: Long candlesticks

Source: Chart courtesy of StockCharts.com
The downtrend lasting six weeks concluded with the first long
white candlestick. Although subsequent price movement tested
the rising support level, it was apparent that the consistent
downward price movement had been halted. But was it a
reversal? The second long white session was exceptionally long,
making the uptrend effective and providing continuation as
well. The new support level held even as price breadth
narrowed in the last part of December.
As the rising support moved, the level of resistance was
marked at $62.50 per share. The brief move above this level at
the end of November failed, strengthening resistance at this
level. It continued to hold through the next two months as well,
setting up an ascending triangle. This was a strong second
confirmation that the primary bull trend was holding and
gaining in strength.
Long candlesticks must be judged as “context” indicators.
While specific reversal and continuation signals cannot be
switched, several indicators (especially single-session ones) take
on meaning based on the context of their appearance. Long
candlesticks are one example.

Long-Legged Doji and Spinning Top

Another candlestick, with only one session that also gains

significance from the context in which it appears, is the doji
session with exceptionally long upper and lower shadows. Both
are required to create the long-legged doji or the near-doji
formation called a spinning top.
The long-legged doji signals continuation when a move is
underway. A single example is not especially convincing, but
when two or more are found chart analysts should pay
attention. For example, the chart in Figure 6.15 exhibited a
continuing downtrend following a flip from support to
resistance.

Figure 6.15: Long-legged doji

Source: Chart courtesy of StockCharts.com

This trend was strengthened not only by the flip but also by the
strong downward price gap that moved price below prior
support; and the fact that this new range held for the next two
months is also noteworthy.

Key Point: The long-legged doji is one of those single-session

indicators whose significance depends on proximity and how (or
if) it is confirmed.

The first long-legged doji appeared in the first session after the
gap. This could have been either a reversal or continuation
signal, depending on whether price held below the declining
line or moved back into the previous range. One month later, it
appeared that the new resistance line was going to hold, as
price did not advance above it in any of these sessions. The
continuing downtrend was strengthened with a second long-
legged doji, which provided a continuation signal. In fact, one
month later, price descended even further, and the long black
session followed by the small session with an exceptionally long
lower candlestick marked the end of the decline but predicted
that the lower price level between $3.50 and $5 would hold but
that prices were not likely to fall any further. Those two
sessions of long black candle and long lower shadow marked a
failure for price to decline any further.
The period after the charted period demonstrated this to be
accurate. By the end of January 2015, price was at $4.13, still
within the newly set range but poised for a reversal to the
bullish side. By the end of February, price had risen to $6.72,
back into the original price range set the previous July before
support flipped to resistance.
Like the long-legged doji, the spinning top must be
appreciated in context. It can mark reversal or continuation. An
example of continuation with exceptional strength was located
on the chart in Figure 6.16.

Figure 6.16: Spinning top

Source: Chart courtesy of StockCharts.com

The first event worth commenting on was the strong breakout

in October. This set up a flip from support to resistance, a move
setting up a continuation signal consisting of two spinning tops
shown by the October and November arrows. Further
continuation of the strong downtrend was found in the form of
a second support to resistance flip at the end of November. In
this case, a strong downward gap took price below support and
asset up a new range under $43 per share. Although the price
did rally above this level over the two months following this
chart, by the end of February 2015 price was within range at
$42.94 per share.

Thrusting and Separating Lines

The two continuation patterns in this section often are confused

with two of the reversals in the last chapter. The bullish
thrusting lines is a continuation signal consisting of a white
session, an upside gap, and a white session opening higher and
closing within range of the previous day. The gap is a key
element of this pattern. This can be confusing in chart analysis,
because the thrusting lines pattern has the same elements of
the piercing lines reversal signal explained in the last chapter.
This is one of the drawbacks in candlestick analysis. Many
patterns are similar (or identical), but one represents reversal
and the other represents continuation. It depends on where
they appear on the chart. A piercing lines is expected to show
up as a bullish reversal at the bottom of a downtrend, or as a
bearish reversal at the top of an uptrend. But the same pattern
is defined as a thrusting lines continuation signal when it
appears elsewhere.
The similarity of two signals with different interpretations
reduces the reliability of both signals. In this instance, both
piercing lines reversal and thrusting lines continuation are
suspect. They should be used as forms of confirmation and only
when additional strong signals appear at the same time.
The bearish thrusting lines is the opposite of a bullish
version: a black session, downward gap, and a white session
opening lower and closing within range of the previous day.
The same caution applies on the bearish side: Because this
pattern is identical to piercing lines reversal, the bearish
thrusting lines is not reliable enough to be viewed as a reliable
continuation signal.

Key Point: Thrusting and separating lines are continuation

signals, but these formations are less reliable than other
continuation signals due to their appearance, the same as
piercing lines reversals.

The distinction here is placement and confirmation. Both

thrusting lines and piercing lines will appear within the current
trend, but they can have opposite meaning. So how can you
decide whether this configuration is acting as reversal or
continuation?
In the continuation (thrusting lines), confirmation can
consist of other continuation patterns or just by the failure of
price to turn in the opposite direction. An example of bullish
thrusting lines is found in Figure 6.17.
 Figure 6.17: Thrusting lines
Source: Chart courtesy of StockCharts.com

Although price reaction is sideways and then downward at first,

in both cases price stopped declining as soon as it reached
support. The primary bullish trend then continued. The two
instances of decline stopping right at the line of support
confirmed the thrusting lines as bullish continuation.
A related indicator is the separating lines, another form of
continuation. A bullish version has a black first session, a gap
upward, and a white session opening higher but closing at the
same price as the previous day. The bearish variety begins with
a white session, a gap downward, and then a black day opening
lower and closing at the same price as the previous day. The
pattern is like the reversal meeting lines, but each day’s color is
opposite. This is what distinguishes the meeting lines reversal
from the separating lines continuation pattern. An example of a
bearish separating lines is shown in Figure 6.18.
 Figure 6.18: Separating lines
Source: Chart courtesy of StockCharts.com

In the bearish signal, the downtrend began with a downward

gap in late July, but prices immediately began moving sideways.
In a consolidation pattern, it is difficult to know whether the
downtrend has failed or only paused. The appearance of a
strong bearish continuation pattern determines the answer.
The downtrend did continue for another month until mid-
October.
A problem with all the reverse and continuation patterns
having similar traits makes them difficult to use reliably.
Reversals (piercing and meeting lines) and continuation
(thrusting and separating lines) are easily overlooked because
of this similarity in pattern and the resulting confusion.
However, in some cases, such as the charts above, the value of
the signal itself can be a determining factor in identifying a
trend as failed or continuing.

Side-by-Side Lines

A set of signals identified as side-by-side are forms of

continuation and they come in four types. The side-by-side
bullish white lines has three sessions: a white candlestick,
upside gap, and two additional white sessions. The side-by-side
bullish black lines starts with a white candle, then an upside
gap, and two black sessions.
In a bearish white side-by-side lines, the first session is black
and is followed by a downside gap and two white sessions. The
bearish black side-by-side lines begins with a black session and
is followed by a downside gap and two additional black
sessions.

Key Point: The strength in all side-by-side patterns is a

combination of candlestick direction and the gaps formed within
the signal itself.

Initially confusing for traders not accustomed to the subtle

differences between similarly named candlestick signals,
viewing these four possible patterns sets up clear distinctions.
Recognizing the beginning white candlestick and upside gap
reveals a bullish trend, and the black candlestick followed by a
downside gap is clearly bearish.
An example of bullish side-by-side lines is shown in Figure 6.
19.
 Figure 6.19: Bullish side-by-side lines
Source: Chart courtesy of StockCharts.com

The uptrend began in late July but then paused for September
and October. The decline in early October could have signaled
the end of the uptrend, but the white bullish side-by-side lines
forecast continuation. This move was confirmed by a second
continuation pattern, the black side-by-side lines in late
October. The trend did not last much longer, topping out in mid-
November before settling into a consolidation pattern that
lasted for at least two months beyond the time shown on the
chart.
A black bearish side-by-sides formation appeared and was
confirmed by a second one on the chart in Figure 6.20.
 Figure 6.20: Bearish side-by-side lines
Source: Chart courtesy of StockCharts.com

The first instance of a continuation side-by-side lines occurred

following a pause in the prior downtrend and short-term
consolidation pattern. The fact that price rose after the first
black bearish signal would have caused concern except for one
fact: prices rose slightly above $27 per share but failed to break
out above resistance at approximately $27.50 per share. This
was the initial confirmation that a continuation was underway.
Final bearish confirmation was found with the second black
bearish side-by-side lines pattern.

Tasuki Gap

The tasuki gap is a strong continuation indicator. The world

tasuki is Japanese for a sash used to hold sleeves in place and,
by the same description, the tasuki gap keeps a trend intact and
moving, working as a form of continuation.

Key Point: A gapping price pattern is a strong form of

continuation when the gap moves in the direction of the trend.
A bullish tasuki starts with a white candle session, an upside
gap, a second white session, and then a black session opening
lower and closing below the opening of the previous session. A
bearish tasuki starts with a black session and is followed by a
downside gap and another black session. A final white session
opens higher and closer above the opening of the previous day.
An example of the bearish version is shown in Figure 6.21.

Figure 6.21: Tasuki gap

Source: Chart courtesy of StockCharts.com

The downtrend began in early September but was not

especially steep. In fact, a rally in late November made it appear
that the downtrend might be over. The decline and appearance
of the tasuki gap was a convincing signal that the downtrend
was still in effect. It continued even beyond the charted period,
moving to $52 per share in late January before prices again
moved upward.

Gap Filled

The gap filled is like the tasuki gap, but with one important
distinction. In both bullish and bearish versions, the final
session moves into the range of the very first day, closing the
gap created between days one and two.
An example of the bullish gap filled is found in the chart in F
igure 6.22.

Figure 6.22: Gap filled

Source: Chart courtesy of StockCharts.com

The bull trend began at the start of August. At the end of

September, the continuation was forecast by the bullish gap
filled pattern. The uptrend did continue as predicted, pausing
only at the end of November before surging upward once again
in December. During January, the month after the period
shown, prices rose to $110 before retreating into the range
shown on the chart. However, the uptrend covering six months
on this chart did not end, and its continuation was predicted
with the bullish gap filled signal.

Key Point: Gaps that fill are strong signals of continuation.

Analysts prefer to see gaps fill because it indicates strength in
the trend.
A problem every investor faces in the use of continuation
patterns is the awareness that all signals may fail. This
observation is applied to reversal patterns in most cases, but it
applies in the same way to continuation. Because continuation
advises no action for those already in equity positions on the
upside or those not in equity positions and waiting for the
bottom to occur, they are not as exciting as reversal. Just as
investors must be aware of when trends are ending, they also
need to track trends as they continue.
The next chapter takes reversal and continuation to the next
step, which is confirmation. No signal by itself should be acted
on unless and until it is confirmed by additional signals,
whether forecasting reversal or continuation. When these
patterns evolve in proximity to resistance or support, the likely
success of the signal, once confirmed, is at its strongest.

Endnotes
1 Bem, Daryl J. “An Experimental Analysis of Self-Persuasion.” Journal of
Experimental Social Psychology (1965): 1, 199–218.
Chapter 7
Confirmation Signals: Turning the Odds in
Your Favor
Because technical analysis demands discipline, the very idea of
confirmation is of the utmost necessity. Ironically, it often is
overlooked or discounted, with emphasis on fast and
immediate action upon spotting a signal, notably a reversal
signal.
Requiring confirmation before acting is not overly cautious
but a sign of maturity in an investor or trader, an attribute of
experience. Once an investor realizes how easily “sure things”
can fail, an appreciation for confirmation develops and builds.
However, every investor also needs to proceed with caution.
The difference between strong or multiple confirmations and
weak or a single confirmation is profound and may easily lead
to ill-timed trades. Is there such a thing as too much caution?
Yes. If you expect multiple confirmations and fail to act in a
timely manner when there are “enough” confirmations in hand,
opportunities are lost.

Key Point: A dilemma for all investors is knowing when enough

confirmations are present. A good rule of thumb is to set
standards in advance, and to then act quickly.

The suggestion in this chapter is intended to overcome the

emotional nature of the market in which impulsive actions
often outweigh objective analysis. The tendency to overlook the
importance of confirmation is one of those observable
problems for investors which, if discipline is applied, can be
overcome in favor of a structured approach to timing of trades
and on a larger scale, to selection to strategies within a portfolio
management plan.

The Causes of Price Movement

A great mystery in all technical analysis is why prices move.

Observing direction of movement and identifying signals is the
primary activity in analysis; but why do prices move?
The long view is that all elements of what appears chaotic
are attributes of supply and demand, growing from
fundamental trends. There is some truth in this, but there is
more. Trends on the technical side often seem to develop with
little or no regard for fundamental strength or weakness.
Technical trends often diverge from what the fundamentals
indicate. Investor sentiment is not always reflected in the
numbers, so price movement is caused by a combination of
supply and demand along with behavioral psychology in the
market. And that contains many elements.
Much emphasis in technical analysis is placed on the
rationale of price movement, represented in patterns and
trends. However, the uncertainties and risks of any attempt to
time trades, especially for short-term price movement, can not
be overlooked. Prices move for dozens of possible reasons, and
investors cannot know with any certainty what underlying
causes are in play during a reversal or continuation. Therefore,
reliance on confirmation is essential, not only to increase the
chances for well-timed decisions, but also to combat the human
element in decision-making, in which impulse, emotion, and
narrow focus on only a few possible elements can easily distort
judgment and lead to poorly timed decisions.
For many investors, reliance on technical analysis is
comforting, based on the belief that the answers are found in
price patterns, trends, and marketwide strength or weakness.
However, this addresses only part of the question about price
behavior. A chartist, relying on price patterns and evolving
trends, may easily overlook the underlying causes of change in
price, even when the answers may be found with further
analysis:
Technical indicators do not reveal causes of market movement. They simply
indicate the proximity of a reflecting boundary. We therefore use technical
indicators only in context of a potential reflective boundary. When creating
models we utilize data only when the data are proximate to a measured high or
low, a potentially precise turning point.1

The “reflecting boundary” refers to a technique in which

probabilities of specific price behavior are expressed within a
range of likely movement based on past trends, resistance and
support, and volatility. This, combined with identified signals
and strong confirmation, adds value to the science of trend
analysis. It allows you to temper the observation of a trend with
an observation of how a specific stock has behaved in the past
and therefore likely to behave in the future.

Key Point: All signals are only estimates of likely outcomes. Even
with strong confirmation, there are no guarantees.

This adds no certainty to the analysis but it does provide a

framework for viewing the behavior of price within the trend.
However, price behavior is only one aspect of trying to
understand why prices move. Of perhaps much greater
importance is understanding how humans behave and why.
This often leads to a deeper understanding of why prices move,
combined with the technical analysis of how price patterns
evolve and reverse or continue trends. The confirmation of
these movements is an attribute not only of how trends move
and change but also of why the price of a specific stock has
evolved in a specific manner.
Anyone who is uncertain about the combination of market
and human behavior needs only to compare the stock charts of
any two companies. Patterns develop independently for
companies, creating a behavioral tendency within the stock
price, even when the fundamentals for the two companies are
identical. This is a symptom of the behavioral psychology of
investors and their perception of a company, its value, future
growth, and even basics like quality of product, experience of
management, corporate culture, and long-term prospects for
sustained growth (in stock prices, market share, dividends,
revenues, and earnings).

Behavioral Psychology and the Market

The principles of technical analysis are based in logic and study

in statistical and realistic assessment of price strength and
weakness—in other words, in the attributes of trends and the
ways in which they proceed or stop. Opposing this methodical
approach to analysis is the overriding emotional and often
irrational behavior of investors and traders. Too often the
emotional responses, notably greed in bull markets and panic
in bear markets, mask even the most obvious responses that
should prevail but that do not. At times of extremes in price
movement in the overall market, rational analysis is easily
ignored as market participants rush to join the majority. Even
when that majority has been shown time and again to be in
error at such extreme times, the impulse to follow often is
stronger than rational thought.
This is a problem, of course, because a majority is difficult to
resist. However, it is also an opportunity. A contrarian approach
to investing is based not simply on the idea of moving opposite
of the majority but on the more logical idea of making decisions
based on analysis and study and not based on emotion. A
contrarian recognizes extreme decisions made in extreme
market conditions and can exploit overreactions by timing
decisions based on trend analysis and not on the far less
rational gut reactions of greed or panic.

Key Point: A contrarian acts not just to go against the majority

but based on logical and rational observation and not on
emotion.

The tendency to overlook and even completely ignore facts

defines the oddity of investor behavior at times when calm
analysis would better serve their motives:
Stock traders make decisions based on psychological factors, including emotions,
and may place undue weight on specific information at the expense of other
relevant data. Different emotional states can have unpredictable effects on
decision-making at different times. Mood can have an impact on cognitive
performance and expectations, while factors such as a series of gains or losses can
have an effect on traders.2

The behavior itself may seem odd when viewed from a

distance, even though investors and traders repeat the same
tendencies over time. The majority is not always wrong but
often makes poor decisions based on identifiable flaws in
thinking. A study of 422 investors drew the conclusion that
specific tendencies were repeated over time:
 The final results [of that study] show that five factors of psychology which are
overconfidence, optimism, herd behavior, psychology of risk and pessimistic [sic]
have influence on investment decisions. To be more detailed, excessive optimism,
psychology of risk and excessive pessimistic [sic] affect positively on long-term
investment of investors while overconfidence and herd behavior have the
negative impact.3

To what degree do these emotional tendencies affect trends?

This is a point of concern for all investors interested in tracking
the trend and its outcome. If emotions are the root cause for
investors to buy or to sell, do emotions also affect the trends
themselves? The past has shown that the mistakes made in the
“herd mentality” of the market are likely to repeat in the future,
so a highly pessimistic conclusion could be that an analyst’s
inability to predict the emotional mood of the market brings all
analysis into doubt.
The solution, however, is strong and brings analytical order
to the emotional chaos of the market. The contrarian approach
to timing and to trend analysis forms the logical foundation of
trend analysis, not emotion. It is true that emotion has the most
immediate short-term influence on price movement, and this is
easily seen in even the strongest trends. The secondary trends
and swing trends that offset even the strongest primary trends
cannot be ignored or denied. At some point, one of those
reversals becomes a new primary trend, so even the most
ardent contrarian must be aware of the rationally-based
analysis. Ignoring the short-term extreme behavior based on
emotion, a contrarian relies on several price patterns, statistical
tendencies, traditional rules of technical analysis (such as the
behavior of price in proximity to resistance and support) and,
more than anything else, confirmation.
Key Point: Contrarian investing demands strong, cold discipline.
Going against the prevailing opinion of a majority is never simple
but may be right often.

The confirmation signal provides certainty in the uncertain

world of stock analysis. It defies greed and panic and provides
the analyst with not the certainty but the high likelihood that
price will behave in a predictable manner and that trends will
reflect the sum of price indicators for reversal or continuation,
all based on whether the immediate signal can be confirmed.

The Flaw of Overconfidence

Among the emotional components of market behavior,

overconfidence may be the most destructive. It blinds the
logical mind. It creates the illusion of certainty when conditions
are uncertain. It convinces the investor that individual success,
knowledge, and ability lead to success. Overconfidence is most
dangerous among those with knowledge in a subject area. If a
little knowledge is a dangerous thing, a lot of knowledge and
experience can be both dangerous and blinding.
Having some knowledge is invariably a flawed condition
because it means an investor is not equipped to analyze the
entire realm of risk involved in investing. However, once an
investor has built a level of skill, increased success may easily
lead to overconfidence. This is justified to a degree, but in a
larger sense it leads to great vulnerability because the
overconfident investor may easily become blinded to the risks
of a decision or range of decisions.
Overconfidence may easily lead to poor decisions. In one of
the largest debacles since the Great Depression, Goldman Sachs
was sued by the SEC for its deal involving collateralized debt
obligations (CDOs) made with Paulson & Co. Paulson, which
retained Goldman Sachs for a fee of $15 million to put together
a synthetic CDO, which ended up containing mostly sub-prime
mortgage obligations. With the collapse of the sub-prime
market, Goldman lost $100 million. At the same time, Paulson
shorted the arrangement through credit default swaps, which
set up a conflict of interest. Certain they would make big profits
on this deal, Goldman Sachs was accused of failing to disclose
material facts and was fined $550 million.4
Why did Goldman Sachs enter this deal based on devices as
risky as sub-prime mortgages? Why did they fail to disclose
material facts? Why didn’t they recognize the conflict of interest
by Paulson in shorting the plan? Was it greed, hubris, or plain
old-fashioned failure to understand the risks?
All these errors, made on a large scale by one of the big Wall
Street firms with great expertise and resources, betray a culture
of overconfidence. Compared to the actions of smaller
organizations and their portfolio management team, or to
highly skilled individual investors, the Goldman Sachs case is
not a typical example. However, it demonstrates that bigger
companies with more resources may be just as vulnerable as
smaller ones to overconfidence.

Key Point: Overconfidence leads to errors in judgment. This

applies to large institutions as well as to individual investors.

Applying the same observation to the decisions to buy or sell

securities based on observed price patterns, the importance of
confirmation can not be ignored. Certainly, Goldman Sachs
should have applied due diligence to ensure that the deal they
entered was both legal and made with full disclosure. They
failed in this. Just as large Wall Street firms with entire
departments of compliance officers and lawyers may fail, so
may financial advisers, money managers, portfolio managers,
and investors. Everyone is at risk to become overconfident in
their abilities to make sound decisions or even in their basic
compliance with the law, as in the case of Goldman Sachs and
their partners. Overconfidence allowed Goldman Sachs to
proceed without performing due diligence, a form of
confirmation that the deal followed the law and with good
practices; it blinded them to the risks they faced, not only in
suffering losses once the sub-prime market failed, but also in
overlooking the need for disclosures and elimination of
conflicts of interest.
For organizations smaller than Goldman Sachs and for
individual investors, confirmation exists on an entirely
different level. However, the risk of overconfidence is
universal. This is expressed in many forms. The most obvious is
a tendency for investors, either individual or institutional, to
overestimate their skill level in making investment decisions.
Along with this tendency is a related tendency to assign success
to superior skill and to rationalize failure outside of the skill set.
Another symptom of overconfidence is the tendency to pick
information that conforms to a set bias. This can relate to belief
about a company, a favorite reversal indicator, and any other
factors that influence objective thought. It is also possible to
hold onto beliefs about a company or “system” for years, even
after evidence reveals that those beliefs are simply false. The
possession of beliefs is very comforting, true or otherwise; part
of the tendency of overconfidence is to resist changing. For
example, an investor who has owned shares of a company for
many years continues expressing confidence in that company
even as fundamentals begin to weaken and stock prices fall.
Overconfidence may be a widespread problem for investors,
perhaps more than many are able or willing to admit. The
solution to this problem is most likely to be found in application
of sound analytical principles. In terms of trade timing and
trend analysis, confirmation is one of the tools you can use to
improve confidence in observed signals and in determining the
true status of the current trend.
As a starting point in identifying when signal confirmation is
the most valuable in the process, resistance and support should
be considered. The principle of proximity is one of the keys to
accuracy in trend analysis and can be used to ensure objective
analytical conclusions in place of overconfidence or emotional
reaction.

Resistance and Support as Keys to Confirmation

Proximity

The role of resistance and support in both reversal and

continuation patterns cannot be emphasized enough. These
price points near resistance and support are the most likely for
successful price movement in the direction forecasted.
Confirmation is yet another factor that will be at its strongest at
these points.

Key Point: Just as reversal is most likely in close proximity to

resistance or support, confirmation is also likely to increase
confidence that reversal is highly likely.
When reversal signals appear and are quickly confirmed by
additional signals, this should increase confidence. However,
when reversal is found right at resistance or support,
confidence should approach 100 percent never quite reaching it
because anything can happen but getting as close as possible.
This also assumes that the reversal and confirmation signals
are strong enough to convince you that the likelihood of success
is high.
An example of reversal and confirmation taking place right
at these key price points is found in Figure 7.1.

Figure 7.1: Proximity—resistance to support flip

Source: Chart courtesy of StockCharts.com

Support began falling in mid-August and continued downward

through mid-October. At both beginning and end of this support
trend, the price was tested, only to be met with strong bullish
reversals: first a bullish abandoned baby and then a double
bottom (confirmed by a spinning top). However, the most
impressive confirmation was found at the point that price
moved through resistance and formed a resistance -to-support
flip and a new trading range. Normally, price moving through
resistance would be viewed with caution. However, the upside
gap filled as a strong bullish continuation signal, and as
expected, the breakout succeeded. The strength of this type of
signal is invariably strong. In this instance, the resistance-to-
support flip and the upside gap filled signal presented creating
a convincing form of confirmation.

Strong and Weak Confirmation

Another way strong confirmation results occur is when signals

combine to make the case. Confirmation can be set up with any
combination of signals, including Western and Eastern
technical signals, volume, moving averages, and momentum
oscillators.
For example, in Figure 7.2, price dropped below support and
immediately gapped even lower. This is a troubling signal, often
forecasting a fast reversal back into range. But the gap needs to
be confirmed.
 Figure 7.2: Strong confirmation—gaps and spikes
Source: Chart courtesy of StockCharts.com

Two strong forms of confirmation appeared immediately after

the initial gap. First was a volume spike, one of the more
reliable reversal signals. Second was a set of two long white
candlesticks, which created a likely bullish move. As expected,
price returned to its previous range with a breakout lasting less
than three weeks.
Another form of multiple signals setting up strong
confirmation can be seen in Figure 7.3.
 Figure 7.3: Strong confirmation—runaway gaps
Source: Chart courtesy of StockCharts.com

The bullish harami was the first reversal signal worth noting on
this chart. If the assumed support level of approximately $103
was accepted (although it held for only two months), the five
sessions below represented a failed breakout with strong
signals. The bullish harami was confirmed initially by the long
white candlestick two sessions latter. Further confirmation
came in the form of runaway gaps.

Key Point: Confirmation takes many forms, but failed breakout

is one of the strongest, since the reaction tends to move price in
the opposite direction from the attempted breakout.

The combination of long candlesticks and runaway gaps was

especially noteworthy given the extremely narrow trading
range that preceded this volatile move. The breadth of trading
was about two points through September, unusually low given
the price range around $100 per share. Breadth began
expanding in early October before the breakout below support,
indicating that a change was coming. However, what at first
looked like a possible bearish trend turned out to be a bullish
breakout, settling into an expanded range between $110 and
$125 (this range lasting beyond the period shown).
The breakout above resistance was also confirmed by a
continuation signal in the form of a bullish white side-by-side
lines pattern. Assuming that resistance was at about $109 per
share, the breakout occurred after the runaway gaps and the
side-by-side lines appeared immediately after the breakout. Just
as reversal confirmation at resistance or support is at its
strongest, so is continuation confirmation. The combination of
reversal and confirmation at support in the mid-$90s and
continuation above resistance at $110 makes a convincing case
for the value of proximity of confirmation signals to both
support and resistance.
Strong confirmation contains specific attributes, including
the strength of price patterns followed by equally strong
confirmation signals. The opposite is also true. Weak
confirmation includes attributes like poor proximity or
misplaced signals, weak patterns, and the failure to break out
above resistance or below support.
An example of weak confirmation is provided in the chart at
Figure 7.4. In this case, the flip from rising support to new
resistance did not lead to a strong bullish trend. In the period
following the one charted, prices evolved into consolidation,
range bound between $80 and $84 per share. The question for
analysts is whether this weak outcome could have been
anticipated in what occurred in the preceding six months.
 Figure 7.4: Weak confirmation
Source: Chart courtesy of StockCharts.com

The chart appeared promising for bulls at first. Support was

rising, and during October the price range expanded rapidly.
However, it did not hold. The signal identified as three black
crows also failed to set up a downtrend for two reasons. First, it
was not a perfect signal and should be defined as a near-three
black crows. Second, it appeared after a period of consolidation
and not at the end of an uptrend. Lacking the correct
placement, this is either a weak signal or a non-signal.
Once the flip from support to resistance occurred, the price
pattern settled again into a consolidation pattern. The bullish
harami appeared to present a case for price to rise strongly, but
it was not able to make a move or hold prices above $84 per
share. The bullish harami by itself is not an especially strong
signal and works best when accompanied by strong
confirmation. In this instance, a weak bullish signal was not
confirmed and the resulting price move failed.

Momentum and Timing of Preceding Trends

Another way in which prices evolve is through a short-term
cyclical pattern of movement. This often involves waves of
alternating bullish and bearish secondary trends or swing
trends. These are ideal for swing trading, but for the longer-
term direction you need to review a period longer than six
months.

Key Point: Momentum is effective in identifying the rhythm of

short-term trend cycles, whether swing trends or secondary
trends.

The chart in Figure 7.5 contains no fewer than seven sets of

signals over six months. The price pattern alternates between
uptrend and downtrend.

Figure 7.5: Cyclical secondary trends

Source: Chart courtesy of StockCharts.com

The movement of price on this six-month chart reveals the role

played by confirmation. The first bullish reversal highlighted
was a piercing lines pattern. The resulting uptrend lasted less
than three weeks before the bearish abandoned baby signal
appeared. After a brief consolidation, a bearish evening star
presented another bearish signal, confirming the abandoned
baby.
At the bottom of the downtrend, a bullish engulfing forecast
trended upward, and this was confirmed quickly by the bullish
tasuki gap signal. A second decline ended with an exceptionally
strong hammer, presenting bullish reversal. This was followed
by an upside gap and a dragonfly doji, which confirmed the
hammer’s bullish forecast.
Even with these short-term trends moving back and forth,
the big picture revealed a broader view of what was going on
with this company. The six-month chart was a consolidation
period ranging narrowly between $23.25 and $26.75 over six
months. Even though the volatility was apparent, a broader
view demonstrated what took place throughout 2014, compared
to the primary bull trend in 2012 and 2013. This is shown in Fig
ure 7.6.

Figure 7.6: Two-year trend

Source: Chart courtesy of StockCharts.com
The entire period shown in the previous chart represented the
last six months of 2014. The longer-term chart reveals that the
entire year of 2014 was the consolidation following a two-year
primary bull trend. The noted retracements were strong, and in
this case, flags represented not only retracement, but
continuation patterns. With the breadth of trading within a
two-point range during the uptrend, a similar breadth
characterized the consolidation during 2014.
This comparison makes an important point concerning all
forms of chart analysis, notably with confirmation signals in
short-term time spans. What appeared at first to be a highly
volatile period was only movement of the secondary trend
within a very narrow breadth of trading during consolidation.
Once the primary bull trend ended, the cyclical secondary
patterns took over. The problem with consolidation is that it
becomes difficult to identify new trends, since there are no
long-term trends to reverse. Referring to the six-month chart,
none of the secondary confirmation signals provided strong
primary trend indications since price was range-bound
throughout the period (and beyond).

Key Point: Confirmation is challenging within a consolidation

trend, since indicators must be interpreted without a bullish or
bearish trend to reverse.

A final example of momentum makes another point concerning

trend analysis. The term “momentum” normally is applied to
the mathematical effects of momentum oscillators, which
measure not the direction, but the speed of a trend. There are
instances, however, when momentum has a somewhat
different meaning. Figure 7.7 presents a case in which declining
support was part of a broadening price formation. As support
fell, resistance rose slowly but steadily. As price broke out
below support, a harami cross signaled reversal and strong
confirmation followed quickly with a white side-by-side lines
bullish signal.

Figure 7.7: Trend momentum

Source: Chart courtesy of StockCharts.com

The momentum in this set of signals included not only a return

into range, but replacement of declining support with a new,
higher level above $60 and, like resistance, on the rise. A
previous declining support pattern experienced a drastic
change once the breakout failed. It led to replacement at a
higher level, and throughout the six months resistance
continued rising in a steady way. The momentum here was all
price-based and revealed a dramatic upward adjustment in the
trading range.

Divergence Analysis and Confirmation

Confirmation provides signals of trend reversal or continuation

with the strongest and most reliable forms located in close
proximity to resistance or support. This is especially the case
when the price gaps above resistance or below support and if
signals appear in the proper location within the trend. A few
important rules apply:
1. A bullish reversal is valid only when it appears within a
downtrend.
2. A bearish reversal is valid only when it appears within an
uptrend.
3. A bullish confirmation is valid only when it appears within
an uptrend.
4. A bearish confirmation is valid only when it appears within
a downtrend.

All these observed rules are naturally associated with

proximity. Price action at resistance or support, or moving
through those price levels, is invariably more significant than
when the same signals are located elsewhere.
The opposite of confirmation is divergence. While
confirmation follows and validates reversal or continuation,
divergence provides a signal even when price moves in the
unexpected direction. The concept of divergence is more often
associated with moving averages (see Chapter 11) or
momentum oscillators (see Chapter 12). However, a more basic
form of divergence is found in unconfirmed signals that fail.
When signals and price do not agree, the price usually ends up
having greater validity than the unconfirmed signal.
For example, in Figure 7.8, two distinct confirmation signals,
both bearish, forecast downtrends that did not materialize.
 Figure 7.8: Divergence
Source: Chart courtesy of StockCharts.com

The first, a thrusting lines signal, appearing during a

downtrend, led to a price decline for three weeks, but the
decline quickly reversed. Looking back to the period before
what is shown here, the first session, a long-legged doji,
signaled bearish reversal and was the highest price point in an
uptrend.

Key Point: A weak trend should lead to caution since it is the

most likely type to experience weak confirmation—and even
failure.

However, the downtrend itself was weak. Breadth of trading

was small, only about one-half point in most sessions. And by
the time the confirmation signal appeared, the downward
movement had been in effect for less than three weeks. This
was not a strong downtrend, and its duration was not
convincing enough to accept the confirmation signal as a valid
indicator of continuation.
The second instance occurred in November after an uptrend
had ended and another downtrend had begun. The same
problems were present in this case as before. Breadth was
about one-half point and the downtrend lasted only four
sessions before the downside gap filled continuation signal
appeared. Price did not fall after the continuation signal but
instead began rising.
Another important point to make about this chart is its
limited overall breadth. During the entire six months, it moves
only 12 points from bottom to top. This is a weak series of price
patterns without any substantial price movement. Over the
preceding three years the same narrow range was in effect.
Although prices did gradually rise, the overall pattern was a
modified consolidation trend without breakouts of any
significance. The continuation patterns on the chart diverged
from price movements and, even without any strength in long-
term trends, the divergence signals provided no real guidance
for price direction.

Fundamental Analysis and Confirmation

For the technical analyst, the problem with fundamentals is a

matter of timing. By the time the latest fundamentals have been
published, considerable time—usually several months—has
passed. The value in fundamentals for stock selection must
involve the analysis of several years of fundamental trends.
Knowing that a lag time makes fundamentals ineffective for
analyzing current prices and for confirming trend reversal or
continuations, the fundamentals serve a different purpose in
technical analysis. Specifically, a correlation between
fundamental volatility and technical volatility points to degrees
of risk and the strength of all signals—reversal, continuation,
and confirmation.
 This lag time is forever present, although changes in
fundamental indicators do eventually become reflected in the
price and in trends of a security. No one knows how long that
will take, but fundamental trends in dividends, cash flow, and
profitability are going to affect price trends in the future: “We
know from experience that eventually the market catches up
with value.”5
Those valuable fundamental indicators can be studied over
several years, and the volatility of trends over time reveals a lot
about volatility in stock prices as well. The areas worth
studying include revenue and earnings (especially comparative
analysis of how the two results grow or shrink together);
dividends (per share and yield); P/E ratio (especially annual
ranges from high to low); and debt to total capitalization ratio
(seeking a steady or declining percentage of long-term debt to
total capitalization). These are the key fundamentals useful for
stock selection and for identifying reasons for technical
volatility. The more certainty you find in fundamental trends
over many years, the more certainty you will also find in stock
trends. This translates to lower volatility.

Key Point: A short list of fundamentals helps identify a

company’s financial strength or weakness. This is reflected,
ultimately, in price strength or weakness.

Applying fundamentals to technical analysis is elusive.

However, fundamental analysis can be used effectively to select
stocks. Once a company’s stock has been added to a portfolio, its
market risks are tracked through technical analysis and close
observation of short-term and long-term trends. This is where
the marriage of fundamental and technical analysis makes
sense. The reliability of fundamental trends is reassuring to a
market whose participants are easily disturbed by any
surprises. Even positive surprises, such as better than expected
earnings, add to the uncertainty about an investment’s long-
term risks. The fundamental trends lead the way and the
technical trends follow and set the course for monitoring risks.

Confirmation Bias

No matter how much caution you take in your role as technical

analyst, and no matter the quality of confirmation you locate, it
remains possible to find exactly what you expect and to ignore
all else. This confirmation bias makes trend analysis an
uncertain science with many pitfalls along the way.
There is the tendency “for people to seek information and
cues that confirm the tentatively held hypothesis or belief, and
not seek (or discount) those that support an opposite conclusion
or belief.”6
In chart reading, confirmation bias translates to a tendency
to see specific patterns that confirm reversal or continuation,
even when the pattern is not strong or is not actually present. A
study of confirmation bias produced several primary results,
including location of price patterns that validated their trading
strategies, even when legitimate forms of those patterns did not
exist.7

This conclusion is profoundly disturbing, especially to anyone

who is sincere about tracking price trends. Who is vulnerable to
confirmation bias? How can it be guarded against? The answer
is reliance on a set of confirmation signals that conform to strict
standards. These include:
 1. A confirmation signal must validate an initial reversal or
continuation signal in proper placement within an existing
trend.
2. The signal is considered strongest when near resistance or
support.
3. An especially strong trend preceding the initial signal and
confirmation is granted more validity than a marginal,
short-term, or weak preceding trend.
4. Whenever confirmation signals are questionable in terms
of strength, or when divergence also exists, the best course
of action is to discount the value of confirmation; at such
times, investors should rely on longer-term trends and wait
for stronger indicators.

The danger of confirmation bias is not limited to finding the

signal desired to fulfill trend expectations (reversal or
continuation). Every investor and trader is vulnerable to
specific trade errors. However, a larger problem, “escalation of
commitment,” is a form of confirmation bias affecting a specific
course of action. For example, a portfolio manager may be
committed to populating a permanent portfolio with stocks
having specific attributes, such as recent history of high bullish
movement. However, as the market conditions evolve, those
very stocks might turn out to be the most vulnerable to reversal
and participation in a bear market.

Key Point: Confirmation bias misleads all investors. Once a

reversal signal is spotted, a close call looks more like
confirmation when it is in fact a weak or even coincidental price
pattern.
An investor or manager overly committed to an aggressive
strategy might not recognize the error, therefore, “confirmation
bias” not only prevents recognition of the high risk but could
even create the escalation of commitment making matters
worse. So, instead of diversifying the portfolio to move away
from high-risk positions, the manager tends to increase similar
positions in the belief that the overall strategy will eventually
work out. This is a set of behaviors broadly called “cognitive
dissonance.”

The tendency has been compared to an individual with a

weight problem who enjoys eating doughnuts. Seeking
conformity between reality and expectations may lead to four
types of behavior:
1. Change behavior or cognition (“I will not eat any more of
this doughnut”).
2. Justify behavior or cognition by changing the conflicting
cognition (“I’m allowed to cheat every once in a while”).
3. Justify behavior or cognition by adding new cognitions (“I’ll
spend thirty extra minutes at the gym to work this off”).
4. Ignore or deny any information that conflicts with existing
beliefs (“This doughnut is not high in fat”).8

Cognitive dissonance in portfolio management is potentially a

severe problem if the manager does not recognize the flaw in
thinking. This begins with confirmation bias and could easily
evolve into escalation of commitment, even to a failed strategy.
Many theories expanding on this idea, or contradicting it,
attempt to rationalize human behavior. However, most
investors who have experienced both profits and losses
recognize confirmation bias as a force in decision-making.
Becoming committed to a favorite type of stock or a specific
company, to a strategy (stocks selected based on high dividend
yield, recent primary bull trends, or stocks with rising revenue
and earnings history, for example) may lead to subsequent
losses when strategies are subject to different market
conditions. No one is immune to error, but analysts may be able
to modify their behavior upon realizing that their past
assumptions do not apply to all markets or to all strategies.
It may be that an investor experiencing a period of successes
may come to believe that a strategy is “foolproof.” This belief is
likely to continue until it stops working. At that point, the
analytical investor will reevaluate previous assumptions and
modify them, but some people will ignore the evidence and
continue a high-risk course. This approach is seen among
investors and managers unable to accept their own flawed
thinking as the underlying cause for losses. It only makes sense
to approach the situation by acknowledging confirmation bias
on many levels (individual confirmation in a single trade,
selection of strategies, and design of a permanent portfolio) and
take steps to overcome the blind spots. The tendency to develop
this bias explains why many portfolio managers rely on input
from several sources rather than a singular source for
decisions.

Key Point: Once an investor starts believing a particular “system”

is foolproof, the groundwork is laid for failure, perhaps even
catastrophic failure.

Individual investors do not have the luxury of consulting with a

team of experts and therefore must rely on their own self-
analysis and ability to spot confirmation bias. Being able to
change course upon discovering the bias is essential to avoid
the escalation of commitment that often follows a period of
losses. This escalation may be based on continuing to believe
what has been shown to be untrue, or based on anger at having
had losses due to various reason. Like an inexperienced chess
player who tends to become aggressive after losing a key piece
(when they should become defensive), every investor is going to
experience losses, and some will be based on poor judgment
from confirmation bias and other blind spots. These instances
can be converted to learning experiences and avoided in the
future.
The purpose of confirmation is to reduce errors in the
timing of trades. Confirmation bias is likely to negate the value
of confirmation and lead to losses that could be avoided with
objective analysis of confirmation on many levels: individual
trades, selection of strategies, and long-term portfolio
management. The most basic form of confirmation bias—
looking for the “right” kind of confirmation and then finding it
—means an analyst is likely to ignore the lack of clear
confirmation and to fail to recognize divergence in its many
forms. However, being aware of these potential blind spots is
the best way to manage them in the future. By constantly
questioning the strength or weakness of a confirming signal,
accepting the instances where confirmation is not found, and
looking for divergence, all help to maintain objectivity.
To properly and accurately track and understand the
characteristics of a trend, confirmation ensures that actions are
taken only when evidence is strong. This requires the process of
critical analysis, looking for and eliminating confirmation bias,
and acknowledging a few facts. For example, confirmation does
not always appear, and even when it does the confirming signal
is not always strong enough to justify a trade (or to decide
whether a trend is ending or continuing).
 Confirmation is relatively easy to spot when strong initial
signals appear. A confirmation signal is likely to follow closely if
it will develop at all. This is a relatively easy process in a strong
uptrend or downtrend. However, during periods of
consolidation, locating signals is difficult. Because no specific
bullish or bearish trend exists, deciding when consolidation is
ending may be among the greatest challenges in trend analysis.
The next chapter examines how consolidation patterns develop
and change.

Endnotes
1 Berg, Milton W. “The Boundaries of Technical Analysis.” Journal of Technical
Analysis, Summer/Fall, no. 65 (2008), http://www.mta.org/eweb/docs/Issues/65%20-
%202008.pdf.
2 Williams, Ray. “Emotion, Not Rational Logic, Determines the Stock Market.”
Psychology Today (September 22, 2013) https://www.psychologytoday.com/blog/wired
-success/201309/emotion-not-rational-logic-determines-the-stock-market
3 Ton, Hoang Thanh Hue, and Trung Kien Dao. “The Effects of Psychology on
Individual Investors’ Behaviors: Evidence from the Vietnam Stock Exchange.”
Journal of Management and Sustainability, 4, no. 3 (August 29, 2014), http://www.goog
le.com/url?sa=t&rct=j&q=&esrc=s&source=web&cd=1&ved=0CB4QFjAA&url=http%3
A%2F%2Fwww.ccsenet.org%2Fjournal%2Findex.php%2Fjms%2Farticle%2Fdownloa
d%2F39897%2F22142&ei=rAxeVc6HB8bYgwS3uoP4Cw&usg=AFQjCNEfo-1AKfwR0M5
AcPoRJdTK0srGqw&sig2=F059xFPKJ5UhZLmJ8mSynw.
4 U.S. District Court, Southern District of New York, SEC v. Goldman Sachs, 790 F.
Supp. 2d 147 (S.D.N.Y. 2011) (No. 10 Civ. 3229), 2010 WL 1508202, filed July 14, 2010;
and SEC Press release, “Goldman Sachs to Pay Record $550 Million to Settle SEC
Charges Related to Subprime Mortgage CDO,” July 15, 2010.
5 Graham, Benjamin. “Factors Affecting the Buying and Selling of Securities.”
(Testimony, 84th Congress, 1st session), March 11, 1955.
6 Wickens, C. D., and J. G. Hollands. Engineering Psychology and Human
Performance, Third Edition. Upper Saddle River, NJ: Prentice-Hall, 2000, pp. 261–62.
7 Weller, Paul A., Geoffrey C. Friesen, and Lee M. Dunham. “Price Trends and
Patterns in Technical Analysis: A Theoretical and Empirical Examination.” Social
Science Research Network (August 2007)
http://digitalcommons.unl.edu/cgi/viewcontent.cgi?
article=1010&context=financefacpub.
8 Festinger, L. A Theory of Cognitive Dissonance. Stanford, CA: Stanford University
Press, 1957, p. 11.
Chapter 8
Consolidation Patterns; The Sideways
Pause
The technical term consolidation has a specific meaning: a
sideways pattern of price movement within a limited breadth of
trading in which neither buyers or sellers can move price to
any significant degree. This period of indecision is a third type
of trend in addition to the uptrend and downtrend.
Consolidation trends take up as much time as uptrends and
downtrends on many charts. However, with the focus of traders
on dynamic price moves, consolidation often is ignored or
discounted. A problem for analysts is in finding a clear signal
that consolidation is coming to an end. Any valid signal must be
located within the context of an uptrend or a downtrend; the
only way to spot the end of consolidation is through
identification of a successful breakout.
Confusion is created by a widespread mixing of terms. Many
books, articles, and online references consider consolidation an
alternative term for continuation, but this is not accurate. A
continuation signal often involves the shape, size, and
momentum found within the trading range. For example,
triangles, flags, and pennants are continuation signals that also
contain consolidation of price represented by a narrowing of
the range.

Key Point: Consolidation is a type of trend moving sideways,

rather than up (bullish) or down (bearish).
Continuation implies that the existing trend is likely to continue
in the same direction. A consolidation trend and confirmation
are valuable pieces of information letting you know that it is
not time to close long positions (in an uptrend) or to enter a
trade (in a downtrend). The continuation signal is a “wait and
see” forecast.
The confusion is aggravated by the many sources that
confuse the two concepts.
Many online and text sources can be found with the same
confusion between continuation and consolidation. However,
in analyzing stock charts, every analyst is aware of the problem
of the sideways pattern, or consolidation. It is very difficult to
determine when it is likely to end because the reversal and
continuation signals, easily located in uptrends or downtrends,
cannot exist in a consolidation pattern; and the period can last
from a few weeks to a year or more.
This chapter makes a clear distinction between continuation
signals (technical signals forecasting that the current trend is
not done yet) and consolidation (a period of sideways price
movement, representing the inability of buyers or sellers to
dominate price movement). There are several ways to recognize
a likely end to consolidation based on volume spikes, gaps,
repetitive signals after a breakout (including continuation), a
plateau (or, pause) after a prior trend and before a new trend
begins, and the Bollinger Squeeze.

Consolidation and its Meaning

Consolidation is likely to be associated with, or part of, a

correction or price movement against the direction of the
primary trend. A correcting secondary trend may begin and
then settle into a period of consolidation. The interruption in
price movement is a natural part of the primary trend since the
driving force (buyers in uptrends or sellers in downtrends) do
not present unchanging levels of interest. Consolidation is a
period in which all market participants pause to decide
whether to close old positions, open new positions, or take no
action.

Key Point: Consolidation often is associated with price

correction or rebalancing of supply and demand. However, the
consolidation trend may last several months or even years, like
any other primary trend.

Because price levels tend to settle into a narrow breadth of

trading during consolidation, some traders view this sideways
trend as less interesting than uptrends or downtrends. Some
analysts refer to this as agreement between buyers and sellers
that the narrow range of price is reasonable to both. However,
by tracking the indicators within the consolidation trend, you
may recognize early signals that a new trend is about to
emerge. It is often true that once price breaks out of
consolidation and starts (or resumes) a dynamic trend, price
movement may be rapid and steep. The breakout after
consolidation may act like a coiled spring whose tension has
built up until it is finally released.
Corrections are invariably described as countermoves of
secondary uptrends against primary downtrends, or as
secondary downtrends against primary uptrends. But
overlooking the sideways correction is a blind spot because
some dramatic price movement may follow this period once it
has been exhausted. If consolidation is the result of
approximately equal supply and demand, this makes sense;
eventually one side or the other takes over. However,
consolidation involves more than the supply and demand
features of the market. It may include perceptions of current
price as being the “right” price for a stock, affected by forces
beyond supply and demand (competitive position, economic
strength or weakness, or the influence of benchmark index
movement, to name a few).
Corrections are usually thought of as high-volatility periods,
but only when they are limited to uptrend and downtrend
movement. A correction evolving into sideways price
movement (consolidation) has an opposite tendency, for low
volatility and low volume, both in a time of narrow breadth of
trading. The consolidation period begins showing signs of
coming to an end when breadth of trading expands and when
volume picks up, especially when it spikes.
Beyond corrections, consolidation also replaces secondary
trends. Rather than setting up an opposite price movement
against the primary trend, a secondary trend can develop as
consolidation. To many analysts, this is not viewed as a trend at
all but as a pause between trends. However, when
consolidation is treated as a secondary trend (moving sideways
rather than opposite the primary trend direction) its analysis
makes more sense. Most traders have a solid idea of how to
react to secondary uptrends and downtrends (signals to look
for, technical patterns, and confirming factors like momentum),
whereas many have no idea how to anticipate the next price
move once consolidation begins. The longer it continues, the
less interested traders are likely to be in the sideways pattern.
However, it is potentially as interesting as a secondary uptrend
or downtrend because, like those dynamic trends, consolidation
will eventually end, and the signals can be spotted in advance.
A consolidation period is called a time of indecision,
implying that it is not a trend. However, if uptrends are
characterized as a time of optimism dominated by bulls, and
downtrends are a time of pessimism dominated by bears, then
indecision is a natural time of balance between the two sides.
The “indecision trend” is just as much of a trend as an uptrend
or downtrend, and it presents its own set of challenges in
analysis and forecasting.

Resistance and Support as Keys to Consolidation

Reading

As with all types of trends, resistance and support are essential

ingredients to understanding the nature of consolidation and to
identifying when the period of consolidation is coming to an
end. The uptrend and downtrend end when reversal patterns
appear, but without any movement within the consolidation
trend, the signals must take a different form. This is where the
breakout is the key to tracking consolidation.

Key Point: A breakout from consolidation succeeds only if a new

dynamic trend is then established. Some breakouts simply
retreat and consolidation does not end.

When traders do not react to consolidation as a form of trend,

they easily overlook the role of breakouts. However, as in
uptrends and downtrends, the breakout is a red flag and should
be tracked carefully. It signals a failure and retreat, often
leading to a successful breakout in the opposite direction; or it
signals a success and new trend with a higher or lower trading
range. In either case, the end to consolidation is possible and at
times likely.
With the power of resistance and support in mind,
identifying breakout from a consolidation trend requires the
same patterns you find in breakouts from uptrend or
downtrend: volume spikes, price gaps, strong signals, and
equally strong confirmation. It is also useful to locate multiple
signals after a successful breakout—either showing likely
reversal or continuation—since the lack of a preceding dynamic
trend makes identification more difficult. Thus, price signals are
needed to ensure that the newly established trend is not likely
to reverse.
Reversal itself needs to be defined for the purposes of
consolidation in a different manner than in a dynamic trend.
Reversal usually means a change in direction from up to down
or from down to up. However, in consolidation, it is sensible to
think of reversal as a change in the trend from consolidation to
bullish or consolidation to bearish.
Once this new definition has been accepted, reversal signals
make more sense. If analysis is fixed on the idea that reversal
refers solely to direction of price movement, it is impossible to
spot how price breaks out of consolidation. If reversal of a
current trend is the accepted definition, it makes sense to look
for change in the sideways movement to a dynamic movement
(bullish or bearish) as an alternative definition of “reversal.” In
that case, the trend is reversed from consolidation to dynamic.
As reversal signals appear in conjunction with a breakout, the
pattern takes on significance and can by studied as a true signal
of a change (reversal) in the consolidation trend.
Breakout is always notable, no matter which kind of trend is in
play. However, consolidation is a particularly difficult trend to
escape. With equal levels of control shared between buyers and
sellers, a strong breakout is not easily accomplished. However,
the consolidation trend can be characterized by different
attitudes, and these may also determine the direction of a
breakout. These attitudes may be:
1. Pause in an existing trend, in which the dominant side
(buyers or sellers) settle out the factors that prevent the
trend from moving in a straight line. In an uptrend, this
pause might be the result of profit taking and in a
downtrend it might be a consequence of nervous investors
cutting losses. The distinction between a consolidation of
short and long duration often is found in comparisons of
the breadth of trading. If the breadth narrows considerably
between a previous dynamic trend and the sideways
movement, it could be a pause; if the breadth remains
unchanged, the consolidation could be caused by other
factors. In a pause, the breakout will be a continuation in
the same direction as the previous trend.
2. Uncertainty about which direction price will or should take
next. This is the most popular explanation for
consolidation. It generally implies that both sides are not
confidant enough about their ability to continue moving
price. In a larger sense, it could reflect uncertain
fundamental trends. A company that has been growing
steadily may have also had a growing price trend; but once
the revenue and earnings growth slows down, what does
that mean? Is the stock still priced fairly or has it become
overpriced? A study of trends in the annual range of P/E
ratio in conjunction with the revenue and earnings trends
could hold the answer. This could be the most difficult form
 of consolidation to analyze since the breakout and new
trend that eventually occurs could move in either direction.
Uncertainty will end only when both sides reach consensus,
meaning one side takes the reins and the other side
concedes.
3. Agreement between buyers and sellers that the current
breadth of trading is fair. In this situation, a breakout is
most difficult because the fundamentals probably support
the price range based on earnings per share and as
reflected in the P/E ratio. The “agreement” consolidation
could last several months compared to the pause and
uncertainly varieties that are more likely to last only a
matter of weeks.

The Triangle Breakout

The triangle is a bullish continuation signal in a dynamic trend.

The ascending triangle forecasts upside breakout and a
descending triangle forecasts downside breakout. The
symmetrical triangle often is found during consolidation as the
breadth of trading narrows with the outcome possible in either
direction.

Key Point: The triangle within consolidation takes on great

importance. Any form of narrowing breadth of trading in
consolidation points to a likely end of the sideways trend.

The shape and meaning of triangles were examined in detail in

Chapter 3, which was focused on resistance and support as
notable in uptrends and downtrends. However, in
consolidation, triangles also play a role in forecasting breakout.
Here, as with many patterns, the ideas of continuation and
consolidation have been confused by many traders and
analysts. It is true that triangles are continuation patterns and
may occur within consolidation trends. When they do, they are
early signals of likely breakout in the indicated direction
(ascending leading to upside breakout and descending leading
to downside breakout).
The symmetrical triangle is of the least value in the
consolidation because, even though forecasting breakout, it
does not tell you which direction. The ascending triangle
consists of a level resistance and rising support. This may occur
within a longer-term consolidation pattern like the one shown
in Figure 8.1.

Figure 8.1: Ascending triangle in consolidation

Source: Chart courtesy of StockCharts.com

The consolidation began in mid-September 2013 and did not

end until the breakout. The consolidation lasted a total of
thirteen months. The dilemma for an analyst is identifying the
pattern leading to breakout. Since the preceding primary trend
was bullish, the ascending triangle works as a deferred
continuation pattern within the period of consolidation.
 A consolidation trend lasting seventeen months is seen in
the chart at Figure 8.2. The consolidation began in April 2013
and extended to the end of the descending triangle in late
September 2014.

Figure 8.2: Descending triangle in consolidation

Source: Chart courtesy of StockCharts.com

The descending triangle began at the start of July and

concluded in late September; the last five months of
consolidation included this bearish continuation pattern. The
previous trend was bearish, lasting from September 2012
through June 2013, a total of nine months. The identification of
the descending triangle as continuation is appropriate.
However, there are two different issues involved in this chart.
First is the prevailing downtrend, which is easily spotted.
Second is the period of consolidation with considerable
duration, including the continuation pattern in the form of the
descending triangle. In this case, the continuation is deferred
many months after the initial downtrend moved into
consolidation for over a full year. The consolidation trend could
be called a primary trend, with the triangle not so much a
continuation of the downtrend occurring a year before but
signaling the end of consolidation.

Key Point: The frustration with consolidation trends is in the

difficulty of identifying change. With no dynamic trend to
reverse, no reversal signals can form.

In this type of pattern, a continuation pattern like the triangle is

not clearly serving as continuation of the previous trend but is
acting more like a signal that the current consolidation is
concluding.

Volume Spikes and Gaps

Finding repetitive patterns on charts is reassuring as it raises

confidence in what appears to be occurring. A good example is
the combination of two of the most powerful signals: volume
spikes and gaps. Figure 8.3 provides an example of an
interesting repetitive pattern of consolidation and breakout.
 Figure 8.3: Volume spikes and gaps
Source: Chart courtesy of StockCharts.com

On the chart in Figure 8.3, the overall volume levels were low
(relatively) for most of the period, with distinct volume spikes
occurring at the same time as breakout gaps. The first volume
and gap combination led to an upside breakout and then an
eleven-month consolidation. It concluded with a downside gap
and volume spike, taking price back to the range a year earlier.
In this formation, the support formed during consolidation
flipped to resistance, which rapidly descended from there.
The next volume and gap combination occurred after a
pause consolidation of three months duration, from February to
April 2014. This was clearly a pause in the downtrend,
confirmed by the narrowing of breadth to only 2 points. The
previous consolidation’s breadth was 5 points and the price
decline that followed expanded to wider breadth as well.
The final instance occurred as price declined and marked
continuation of the downtrend. Although volume was higher
than typical volume through the two years, it was a marked
difference from the strong spike marking the price gap. This
confirmed a likely continuation of the primary downtrend.

Breakout Signals

In every trend, including consolidation, you seek breakout

signals of convincing strength to set up a new dynamic price
move and new trend. However, because consolidation is
normally the most difficult trend to escape, you may also need
to locate multiple signals of move, reversal, and continuation,
along with additional confirmation from other signals (such as
volume spikes).
Figure 8.4 is a two-year chart with a period of consolidation
extended for approximately six months. A brief but revealing
pattern emerged. Prices broke out above resistance and
remained there for three months and then retreated into
consolidation range before finally breaking and remaining
above resistance in March 2014.

Figure 8.4: Consolidation leading to uptrend

Source: Chart courtesy of StockCharts.com
An analyst would have to ponder the reasons for the price
activity between September and December 2013, the period in
which the consolidation trend was ending. The chart does not
reveal any reasons for the move upward or whether the
breakout starting in November would succeed.

Key Point: In a consolidation trend, more so than in bullish or

bearish trends, the problem is one of uncertainty—of duration,
breakout success, and signal strength.

Breakout from consolidation is likely to be tested just like

breakout from uptrends or downtrends. This chart reveals that
in the entire month of January 2014, price did retreat into
consolidation range but then moved strongly into a new
primary uptrend lasting for the rest of the year. The key to
understanding the breakout, test, and success was found
between August and December 2013. This period is shown in Fi
gure 8.5.
 Figure 8.5: Uptrend signals
Source: Chart courtesy of StockCharts.com

The chart in Figure 8.5 is a micro view of the larger chart,

showing a slice of consolidation at the point of breakout, and
the relevant signals that forecast this bullish move. The first
event was the downtrend from mid-July through the end of
August, a secondary trend of six weeks within the primary
consolidation trend. Even though there was no primary trend to
reverse in consolidation, a secondary trend did provide the
kinds of signals needed to forecast the end of the trend. The
downtrend bottomed out and immediately provided strong
bullish signals. These consisted of two bullish engulfing signals
in close proximity. Next came a two-week bullish swing trade
accompanied by three volume spikes. This was very unusual,
especially given the difference between these three consecutive
spikes and the rest of the chart’s volume levels.
A bearish swing trade followed but was quickly countered
with another bullish engulfing signal. From this point onward,
the new primary bull trend was underway. Two continuation
signals confirmed this, thrusting lines and an upside gap filled.
When the chart is viewed in a shorter time span and all the
signals can be viewed, the breakout and new trend are visible
and strongly communicated. In the previous chart, there was
not enough detail to fully understand what signals forecast the
breakout or why it succeeded.

Consolidation Plateaus

The tendency for consolidation is to act as either a pause

between longer-term primary or secondary trends or to replace
one primary trend with another. A consolidation primary trend
is an idea often not appreciated by analysts and investors.
Dynamic trends often move in stages, pausing periodically
while investors decide whether to take profits or cut losses.
Pauses may also be caused by earnings to be announced soon
but accompanied by concerns that a surprise might be arriving
as well. At such times, a wait and see attitude among buyers
and sellers could lead to such a pause.

Key Point: Some consolidation trends represent a form of

secondary plateau or pause in the primary bullish or bearish
trend.

A consolidation trend is at times a pause as well but it is more

likely a legitimate primary or secondary trend marking a
period between uptrends or downtrends. Just as some patterns
move back and forth between bullish and bearish price
movement, other patterns move back and forth between
uptrends and consolidation, or downtrends and consolidation.
These distinct patterns, in which consolidation may last many
months, are plateau trends.
Figure 8.6 provides an example of a chart with two plateaus.
The first plateau lasted approximately eight months before an
upside breakout led to a five-month uptrend. This was followed
by a shorter-term consolidation plateau of six months before a
downside breakout.

Figure 8.6: Consolidation plateaus

Source: Chart courtesy of StockCharts.com

Viewing these plateaus on a two-year chart provides a good

broad view. But are these breakouts easy to spot in the
immediate term? How do you know when consolidation is
about to end and the direction price is likely to move?
Figure 8.7 provides a narrow view of the first breakout,
summarizing six months of consolidation. This chart
demonstrates that toward the end of the plateau consolidation,
clear directional signals emerged, led by the breakout above
resistance.
 Figure 8.7: 2013 plateau
Source: Chart courtesy of StockCharts.com

The breadth of trading narrowed before this breakout. In the

first half of the year, breadth ranged between $65 and $53; in
the second half, it narrowed between $65 and $60, less than
half the previous breadth. This was the first signal that
consolidation was likely to end soon.
By mid-September, a two-week uptrend had formed within
consolidation, repeating one nearly identical a month before.
These repetitive swing trends moving price from $60 to $65
resulted eventually in the breakout. But was this a true
breakout? Moves above resistance (or below support) often fail,
especially when the range has been so narrow for so long.
The answer was found in two ways. First, in the second half
of September, the prior resistance was tested but price never
fell below that level. Then, in October, two reversal signals
appeared, both three white soldiers patterns, quite close
together. This was a strong set of signals indicating the start of a
strong bullish run.
Finally, the uptrend was confirmed with a bullish thrusting
lines, setting the course for the price trend through the end of
the year. Referring to the two-year chart, this bullish trend
continued into April before settling back into a new
consolidation plateau trend.
This second plateau could have represented a pause in the
uptrend or a plateau that could lead to a new downtrend. Figur
e 8.8 shows a consolidation plateau with a pattern very similar
to the previous example of a plateau.

Figure 8.8: 2014 plateau

Source: Chart courtesy of StockCharts.com

The plateau began in March and had a range of $115 to $95. The
August and September breadth narrowed considerably to
prices between $105 and $95, half the breadth of the first
segment of the plateau.

Key Point: Consolidation trends are challenging due to the

absence of reversal, but other signals—like narrowing breadth—
anticipate change soon.

The narrowing breadth was the first signal that consolidation

was coming to an end. However, it did not provide a specific
indication of the direction of a breakout. The daily breadth of
sessions had narrowed considerably, gradually evolving
downward but rarely moving more than two points in any
session. Once price broke below $95—for the first time seven
months—the likelihood of a successful bearish breakout was
presented.
Two bearish reversals, both three black crows, appeared
immediately. Neither of these were perfect examples of the
patterns but they were close enough to indicate that price was
likely to continue moving downward. Next, two additional
reversals appeared, both bearish engulfing patterns. Finally,
after price continued sideways for another three weeks, a
bearish doji star completed the reversal cycle.
These reversal signals—five in all—are examples of multiple
confirmation needed to confirm that the consolidation trend
has ended. A final signal was a bearish side-by-side lines, a
continuation pattern. This busy chart was characterized by a lot
of uncertainty. The period between the breakout in October and
the final reversal signal in November could be characterized as
a two-month consolidation trend, but it is more reasonable to
identify it as the beginning of a new downtrend with residual
uncertainty. This uncertainty dissipated over the two months
with repetitive bearish reversal signals before finally moving
down below $70 per share.

The Bollinger Squeeze

The tendency for breadth of trading to narrow as consolidation

ends is a variation of the triangle. This continuation signal in its
various forms (ascending or bullish, descending or bearish, and
symmetrical, either bullish or bearish) are additional forms of
narrowing breadth; however, these patterns are more often
seen in uptrends and downtrends.
 In a similar way, the pennant is a short-term symmetrical
triangle that may reflect a coming reversal or merely a
retracement of the current trend. However, pennants (and
flags) are not associated as much with consolidation trends. One
form of this narrowing tendency that often leads to strong
breakout signals is the Bollinger Squeeze.

Key Point: Narrowing breadth often is a key to the end of

consolidation. The Bollinger Squeeze is a reliable pattern
anticipating breakout.

Bollinger Bands were discussed in detail in Chapter 2 and are

revisited here as part of the analysis of consolidation. Figure 8.9
shows a one-year chart with the squeeze highlighted.

Figure 8.9: Bollinger Squeeze

Source: Chart courtesy of StockCharts.com

The six-point range characterizing this period of consolidation

narrows to less than two points in the month of September.
Although the period of this narrow breadth is a small part of
the chart, it lasts for most of the month. The squeeze reflects
low volatility in anticipation of high volatility and, in
consolidation, possible breakout. The Bollinger Bands width
narrows, both the upper and lower, as price tests resistance,
retreats to support, and finally breaks out on the top quite
strongly.
The success of the breakout is confirmed by the last two
weeks in November when the upper Bollinger band is violated
by price; and at the same time, the lower band declined far
below. This reflects the averaging effect of consolidation, versus
the upsurge.
Taking a closer look at the breakout period, a strong bullish
reversal is followed by an equally strong confirmation, both
containing price gaps. These are shown in the six-month chart
of the same stock in Figure 8.10.

Figure 8.10: Breakout reversal and continuation

Source: Chart courtesy of StockCharts.com

As price tested resistance and then retreated down to the level

of support, a bullish morning star reversal signal formed. This
included a large price gap and immediate turnaround in price
direction. Although this pattern occurred at the end of
consolidation, the large breadth and price movement in the
three sessions of the morning star provided a strong signal that
a bullish breakout and new trend was likely.
This was confirmed a month later by the gapping
continuation signal in the form of a bullish side-by-side white
lines pattern. By the conclusion of the period charted, Bollinger
Bands returned to a closer tracking of price, notably the upper
bands.
The typical breakout tracked by Bollinger Bands occurs after
the squeeze, with bands widening as the breakout occurs. This
example is an exceptionally strong one because the initial
upper move, followed by a downward move, sets up the bullish
trend to follow. The key element of this sudden volatility was
the failure of price to fall below support just below $72 per
share. After the morning star, price fell back into a narrow
range of less than 1 point for two weeks before the trend
strengthened. However, the difference between this narrow
range and the previous consolidation’s narrow range was the
Bollinger Bands. In consolidation, the Bollinger Bands tracked
price very closely; in the late October period the distance
between price and both upper and lower bands was
considerable. This signaled that price was not likely to remain
in the previous consolidation range. In this case, Bollinger
Bands was the determining factor in coming to this conclusion.

Key Point: Bollinger Bands width is a key to identifying

consolidation trends and when they are likely to come to an end.

Helping in the analysis of consolidation breakout is a related

indicator called the Bollinger Bands width. This is the distance
between upper and lower bands. At the end of July, the band
width was only 4 points. However, once the squeeze set in by
the end of September, band width had cut in half to only 2
points, a strong indication that the squeeze was underway.
After the morning star, a big change occurred as band width
moved to 5 points in a matter of one week; and during the
uptrend, it was as much as 12 points. Expressed as a
percentage, a 4-point band width at average price of $75 per
share is only 5 percent; and a 2-point band width with average
price at $77 is 2.5 percent. The breakout band width of 5 points
with average price at $76 was 6.5 percent; and finally, a 12-point
band width with average price at $81 was nearly 15 percent.
Another technical read on the strength of the reversal in
mid-October was location of price within its trading range. With
price falling to about $72, it was at its lowest point since the
previous March, or seven months prior. Any time price is
located at its six-month (or longer) low during consolidation, an
upside breakout is likely. By the same argument, when price is
at resistance and at its high for six month or longer, a bearish
breakout is likely.
These generalizations point to a problem with the Bollinger
Squeeze. It anticipates breakout but does not provide direction.
For this, you need to find confirming signals. On this chart, the
upside breakout occurring after the morning star (and
confirmed by the side-by-side white lines) was convincing
evidence that the breakout had succeeded. The initial
confirmation of the bullish reversal candlestick (widening
Bollinger Bands and band width) could be enough of a signal to
trade on this stock. If so, it could be bought at approximately
$76. Waiting for the additional confirmation in mid-November
would have meant buying at about $82, meaning the entire
bullish trend would have been missed. As things turned out,
price did not continue rising above the ending level between
$81 and $87 and by March 2015 had begun declining in a new
bearish trend. If Bollinger Bands and the Bollinger Squeeze are
used as confirmation at the point of breakout, a trade can be
made in a timely manner, as consolidation ends.
One potential problem in relying on breakout as a
confirming signal is what has been termed a “head fake.” This
occurs when price moves above the upper band (as in the first
two weeks of October), but then retreats back below the band.
This also occurs on the downside when the head fake takes
place below the lower band only to reverse back above the zone
between the bands. This bull trap or bear trap formation occurs
with promising signals, but it emphasizes the importance of
confirming signals.

Key Point: In consolidation trends, false indicators can lead to

poorly timed decisions. The solution is to act only when strong
confirmation is present.

Continuation is a difficult trend to break because it represents

agreement between buyers and sellers about the breadth of
trading. The standoff may last a few months or a year or more,
in which case consolidation becomes a primary trend. Bollinger
Bands and the Bollinger Squeeze are very useful in managing
price movement and in recognizing the difference between a
true breakout and a head fake.
The next chapter introduces one of the strongest forms of
signals (whether initial or confirmation), represented by
volume. Beyond the volume spike, several calculated indicators
provide excellent signals of coming price trends and changes.
Chapter 9
Volume Signals: Tracking Price Trends
Volume is often viewed only as an indicator to confirm price signals or to be
used only in swing trends. However, volume can provide much more,
including signals and divergence for longer-term trends, such as spotting the
end of uptrends, downtrends, and consolidation.
Divergence is one concept that applies in many volume indicators. You
expect to see volume increase as price movement accelerates. But what does
it mean when volume contradicts price? In many instances, divergence
should not be ignored; it could reveal that the trend currently underway is
likely to end soon. This is where confirmation bias plays a role. If you find a
reversal pattern, for example, the tendency is to look for signals that agree.
This bias may ignore divergence because it provides a contrary signal.

Key Point: Volume signals tend to confirm price but may also offer divergence.
This predicts the end of a current trend.

In this chapter, volume indicators are described and shown on charts, both
for confirmation and divergence. Any signals accompanying price add to your
confidence level and may improve your overall trend tracking abilities.

How Volume Confirms Trends

The first issue to address is whether a current trend is likely to continue. One
approach to trend analysis is not to take action until a signal appears
forecasting reversal. However, by the time you find and confirm this reversal,
it might be too late to time a trade profitably. Volume signals can be used as a
confirming signal, providing confidence that the trend is not likely to end in
the immediate future.
With price analysis taken by itself, it often is difficult to decide whether
the trend is strong or weak. Just because price is moving in one direction with
strong momentum, it does not tell you whether it is due for reversal. Every
investor knows that prices tend to overreact to immediate news, and that
exaggerated price movement gains momentum on its own even when not
justified. However, when the price pattern is viewed along with volume, the
body of information is more complete. In a sense, price is only half of total
trend analysis. You also need to see confirmation of trend movement in what
takes place in volume.
At times, volume is a better indicator than price for shifts in supply and
demand. When price movement becomes extreme (meaning greed takes over
near the top of an uptrend and panic dominates the bottom of the
downtrend), it is not always easy to track the trend and find signals to
identify the true price peaks. At such times, price reflects supply and demand,
perhaps to an irrational degree; but volume identifies the strength or
weakness of these forces and shows when one side shifts to the other
(forecasting a change in direction for price as well). This solves the all too
common problem of timing for fast-moving reversals. With price alone, the
reversal may be spotted when it is too late to time trades. With volume, often
acting as a lead indicator, the likely reversal is spotted earlier. Most technical
indicators lag behind price or occur at the same time; but volume is more
often a leading indicator.
Volume signals also track large block trades by institutions. So smaller
institutions or individuals may spot short-term volatility in price and not
understand what it means. But volume reflects trading in the number of
shares, so it provides an accurate tracking mechanism for most of the market,
represented by institutional and high frequency traders (HFTs). This is where
most of the volume occurs, with HFT accounting for at least 50 percent of all
trades in the United States.1
The problem of HFT activity is not limited to volume of trades but may
also include manipulation of stocks prices. In 2014, the Securities and
Exchange Commission (SEC) levied a $1 million fine for rigging prices “of
thousands of stocks including eBay Inc. for at least six months in 2009.”2

Key Point: High frequency trading dominates market volume, which also
brings into question whether changes in volume are valid signals or merely
creations of HFT.

The problem of price manipulation is a serious one and, given HFT activities,
it might become worse in the future. However, as a separate issue, trend
analysis is not as much concerned with why a trend develops but how long it
will last, how far it will move, and when it will end. Focusing on this aspect of
the question, volume reveals as much as price, notably when high levels of
trades occur in short time periods, including the fast-paced HFT trades that
present a problem for the modern, fast-paced algorithmic trading platform.

Confirmation Trends with Volume

A stock’s price trend, when confirmed by volume, is easy to spot. Price

movement, along with rising volume signals, indicates strength, and when
volume falls, it indicates that the trend is weak or getting weaker. When the
two disagree, trend analysis takes on a more interesting form. However, the
most basic relationship between price and volume is agreement concerning
price and volume of trades.
Figure 9.1 demonstrates how this works. This stock was undergoing a
primary bullish trend through the two years shown in the chart, and
throughout, strong price surges were confirmed by volume.

Figure 9.1: Rising volume and rising price

Source: Chart courtesy of StockCharts.com

The primary trend was marked clearly. The first upward surge lasted for five
months and was mirrored by rising levels of volume, culminating in a two-
session volume spike. The second significant event was the price breakout
above resistance, also mirrored by rising volume up to a spike following the
breakout. This breakout also created a flip from prior resistance to new
support, a particularly strong confirmation of the uptrend’s success. Two
additional surges in price were accompanied by volume surges and smaller
spikes. Finally, volume settled to relatively low levels as prices continued to
hold above support in the later portion of the chart. This represents a settling
down of both price and volume. In other words, both price and volume
proceeded without the repetitive volume spikes, so volatility was also
reduced.
A subtle but key attribute of these volume surges was that they acted as
leading indicators. This was crucial in the surge taking place as price moved
above prior support, a point where the continuation of the uptrend was by no
means a certainty. The combined price and volume surge increased
confidence in continuation on this chart.
The same mirroring of price by volume also occurs in downtrends. When
a downtrend is accompanied by rising volume, it indicates strength in the
trend; however, when volume begins to decline, look for confirmation that
the trend is weakening and might be due for reversal or consolidation.

Trends with Volume-Marked Breakouts

Volume often marks changes in the trend other than reversal or continuation.
There are times when unusual price patterns and volume spikes together.
This should draw your attention by revealing that something in the trend has
changed.
For example, the chart in Figure 9.2 shows specific instances of price
peaks.
 Figure 9.2: High volume at price peaks
Source: Chart courtesy of StockCharts.com

Large volume spikes appeared, which signaled some type of change in the
current trend. It is easy to assume that it always marks reversal, and once
price gapped down and back into the previous range with another volume
spike the assumption would make sense, but as this chart reveals, only the
first volume spike was accompanied by a breakout; the rest were failed
breakouts based on rising resistance (in October 2013 and March 2014) and
support (in June 2013 and January, March, and October 2014).

Key Point: Volume spikes are associated with breakouts, but this does not
mean the breakouts succeed consistently.

Another repetitive pattern is a combination of high volume immediately

before price dips to low levels. This activity often is accompanied by gapping
price movement and may either mark a coming reversal or confirm the
existing trend. To determine the meaning of high volume at price low levels,
recognize the volume spike as an initial indicator and then seek other
indicators. The volume spike often is one of the strongest reversal signals, so
look for breakout price movement, reversal, and the trend in both resistance
and support to decide what the volume and price pattern foreshadows.
An example of a chart with numerous volume spikes at the point prior to
price dipping to low levels is found in Figure 9.3.
 Figure 9.3: High volume before price lows
Source: Chart courtesy of StockCharts.com

This chart in Figure 9.3 displays remarkable consistency. At each volume

spike, a decline to a lower price occurred. All of these price moves were
accompanied as well by gaps. This implied that volume and price gaps are
related. This is not always the case, but the combination of the two does add
strength to what the pattern revealed.
The first instance involved price flipping from previous support to new
resistance. Once new support was established after the second volume spike
and price decline, it lasted for eight months, from June 2013 through January
2014. The third and fourth volume spikes moved price even lower and set up
a new resistance, which held for eleven months, from December 2013
through October 2014. In September, price tested resistance but then gapped
lower as the volume spike appeared. The last instance had price declining
from resistance and then gapping above resistance for what appeared to be a
new bullish price move. In fact, price did move to the mid-$50s by March
2015.
This pattern—volume spikes with decline to low price levels—provided a
clear view of how price momentum works in conjunction with volume and
how the two often are found as resistance or support and confirmed and then
broken.
Another interaction between price and volume was found when volume
spikes after a breakout above resistance or below support. This normally
forecasts a failure in the breakout and return to established range. However,
it also is found in many cases of flips from resistance to support or from
support to resistance.

Key Point: When volume spikes occur after breakout, it may predict a failure
and later return of price into the previously establish range.

Figure 9.4 presents a chart with examples of both failed breakouts and flips
from one breadth limit to the other.

Figure 9.4: High volume after breakout

Source: Chart courtesy of StockCharts.com

The chart in Figure 9.4 is yet another example of consistency in volume-

related patterns. When volume spikes appear after breakout, one of two
events is likely to occur next. The most frequent event is a retreat into the
established range; this occurred in the first and second instances of breakout
and volume spike. In March 2013, support was tested at the time of a
downward gap and volume spike, but it retreated into range immediately. A
second support test followed in late August. However, the pattern is not
always going to occur. For example, in late May price broke out above
resistance for less than two weeks and only a small bump in volume
occurred, not big enough to be defined as a spike.
 The third breakout was interesting as it represented a flip from resistance
to support. It was a strong move and support held. The fourth breakout tested
support twice while volume spiked once again, but the level held. The next
instance represented yet another flip from resistance to support and
contained both a price gap and a volume spike with support level holding.
The last spike on the chart was the strongest one. This set up an interesting
new bullish move in the stock. By mid-March 2015, the price had advanced
another 10 points to the mid-130s and set up support at $113 per share. This
was yet another example of a long-term primary bullish trend with support
rising three times in November 2013, May 2014, and December 2014. This is
an example of the plateau pattern seen in many primary trends; by
establishing ever higher levels of support (or in bearish trends, ever lower
levels of resistance), the trend becomes stronger. In comparison, a trend that
moves relentlessly in one direction without pause should cause concern
because a reversal is likely to be sudden and extreme.
Just as high volume following breakout indicates strength in the prevailing
trend, low volume after breakout tells you the opposite, that the trend is weak
or weakening. An example of this pattern is seen in the chart at Figure 9.5.

Figure 9.5: Low volume after breakout

Source: Chart courtesy of StockCharts.com

On the chart in Figure 9.5, the long-term trend began with a weak bullish
move. As price moved above resistance in early May 2013, volume spiked, but
it immediately retreated to a three-month low volume trend while price met
resistance at approximately $36 per share (and began rising from there).
A breakout above resistance lasted only about six weeks. After the retreat,
volume declined strongly, revealing that a lasting bullish trend was not likely.
A final breakout below support at the beginning of October was also followed
by a failed attempt at a bearish move and price returned into range. This also
marked the beginning of a consolidation period lasting into March 2015.
A repetitive pattern was found after each breakout. Not only was volume
low or on the decline, but big moves occurred at the same time. These
breakouts all failed, but there was a common element to them. The low
volume revealed overall weakness in the breakout itself, and ultimate failure
of each instance forecast that consolidation was likely to continue far ahead.
Given the overall weakness in the long-term primary trend, even with the
small increases in trading range (from mid-$20s to mid-$30s over two years),
the consolidation period that followed portrayed the company’s technical
trends as weak.

Key Point: Low volume indicates weakness of breakouts often seen as a

symptom of weak primary trends.

When long-term technical weakness is found (e.g., long-term bullish trends

that move only slightly) the problem often can be traced back to weak
fundamentals. In the case of GM, this is true. Over the four years through
2014, revenues were up each year, but net profits were down, a very
disturbing trend. In the same period, the debt to total capitalization ratio
(long-term debt as a percentage of total capitalization) rose each year, tripling
from 6.6 up to 18.4 (The long-term debt to capitalization ratio is a percentage,
but is reported numerically and without percentage symbols. In this case, the
conclusion was that debt represented 18.4% of total capitalization by the end
of the period.) Overall, both fundamental and technical trends were weak
and declining.

Trend Climax and Gap Patterns

A trend climax is likely to be accompanied by volume spikes or surges, as well

as by long days (broad trading range within a session), gaps, and strong
reversal signals. The trend climax often sets up exceptionally strong reversal
signals and confirmation.
 For example, the chart in Figure 9.6 covers two years and highlights
several features: a six-month flip from resistance to support, then back to
resistance; a volume surge; a downtrend climax with a very strong volume
spike; and then a return to very low volume and rising prices. The two-year
period was a primary bull trend.

Figure 9.6: Trend climax: two year chart

Source: Chart courtesy of StockCharts.com

Even though this was a bullish trend over two years, there were several
overall weakening signals. First, the downtrend climax itself indicated
bearish pressure on the trend. Second, after the volume surge, the continuing
uptrend was accompanied by exceptionally low volume. This could indicate
that the uptrend was exhausted. In fact, by March 2015, the trend had
reversed, and price declined to under $14 per share, a fall of about 25 percent
from the high on December 31. The trend climax does not always lead to
strong continuation but might also be an early warning that the current trend
is losing momentum.
A look at the six months between April and September in Figure 9.7 shows
how the downtrend climax was anticipated in reversal and confirmation
signals, concluding with very low volume and the end of the uptrend with
narrowing range in sessions.
 Figure 9.7: Trend climax: six month chart
Source: Chart courtesy of StockCharts.com

A closer look at the period surrounding the downtrend climax revealed a

series of signals that explained what occurred and why the primary trend
reversed in 2015. The downtrend climax occurred at the point of the volume
surge culminating with a strong spike. This represented the bottom of a
bearish secondary trend and was marked by a double bottom that also
formed a bullish reversal in the form of a piercing lines signal. Even with the
strong bullish signal, price did not move much after until the three white
soldiers appeared, setting up a clear bullish move. This was confirmed with
the bullish thrusting lines continuation signal.

Key Point: Even after strong volume signals and equally strong confirmation,
price reaction may take time. Delays in response are not uncommon.

However, the reversal and bullish trend did not last long. By the end of the
period, volume had declined to the lowest levels on the chart, and daily price
movement also narrowed. This change and growing weakness in the
combined price and volume anticipated the downtrend that followed in 2015.
The uptrend shown on the chart in Figure 9.7 carried prices higher through to
the end of 2014, but the weakness revealed that the trend would not move
any further.
 Volume spikes often are also marked by price gaps. At times, these
consistently mark spots where resistance or support are tested or where
retracement begins. A volume surge leads to a gap, then a brief retracement,
and finally continuation of the trend. With the location of additional signals, a
change in the slope of resistance or support may also mark the point of
reversal. For example, the chart in Figure 9.8 contains seven volume spikes
accompanied by gaps, all of which have significant meaning for the trend.

Figure 9.8: Volume spike with gap

Source: Chart courtesy of StockCharts.com

The first two spikes represented continuation with confirmation in the form
of retracement moves appearing immediately after the spike and above the
gap. In early September, price began consolidating in a four-month trend,
representing either a pause in the uptrend or the point where the trend has
ended. The outcome turned out to be the end of the trend, with the final
upward price move located in early February with a volume spike and gap.
The price moved briefly above $100 marking the top of the uptrend.
A new support level was set at approximately $55. This was tested in early
May with a downside gap and volume spike; however, price returned into
range. At the same time, resistance—starting at the peak of $100 per share—
began declining through to the end of the period shown. This was tested
briefly at the beginning of September.
 The last volume spike was the largest on the chart and it was accompanied
with a price gap yet again. The combined level of support and declining
resistance formed a descending triangle forecasting a new downtrend. This
forecast was accurate. By late March, price had declined to about $44 per
share, moving below the level of support shown on the chart.
Throughout the two-year period, the signals were clear, all consisting of
volume spikes and price gaps. The three retracements led to a peak in the
uptrend and from there prices began a new primary downtrend. The chart
was split between the primary uptrend and the start of the new downtrend.
Each significant point was marked with visible signals. The first three
consisted of volume spikes, gaps, and retracements moving above the price
level that became new support and marking the top of the uptrend. Following
tests of both support and resistance, price formed into a descending triangle
anticipating the downtrend that followed.
The chart in Figure 9.8 is an example of how volume accompanied price to
first track a trend over a full year and then to lead the downtrend that
followed. It is one of the ways in which volume spikes confirm what price
patterns reveal.

On Balance Volume

Beyond the volume spike, several calculated volume signals aid in

interpreting the trend. First among these is on balance volume (OBV). This is
among the most popular of volume indicators, providing the greatest value
when the indicator moves opposite the direction of price. This forecasts
weakness in the prevailing trend. OBV was first introduced by Joseph
Granville.3
OBV calculates the daily levels of accumulation and distribution in
volume. In a day when prices move upward, that day’s volume is added to the
previous sum of volume; and when the day’s price declines, that day’s volume
is subtracted. This is a simple equation, but it also points out a flaw in OBV.
The calculation makes no distinction between a session moving slightly
versus a session that moves many points. In both cases, up-day volume is
added and down-day volume is subtracted.

Key Point: OBV is a popular volume indicator, but it makes no distinction

between big moves and small moves in either direction.
The observation analysts make about OBV is that it may confirm potential
breakout moves. Rising OBV may accompany moves strong enough to break
above resistance, while falling OBV warns about potential breakout below
support. However, OBV is most valuable as a confirming indicator when price
proximity is at the critical stage, close to resistance on the rise or close to
support on the decline. This is where moves in OBV in the same direction
confirm what appears to be a breakout that may be about to occur.
Because OBV is based on price moves, it is not always valuable as a
directional indicator, even when confirming stronger price patterns.
However, OBV becomes more valuable when it represents divergence from
price. A declining OBV during a period of rising prices, or a rising OBV when
prices are falling, foreshadows reversal. OBV provides a signal of this, but
independent confirmation is essential before accepting divergence as a
certainty.
An example of divergence in OBV is shown in the chart in Figure 9.9. In
this chart, the first four months reveals a price decline while OBV rose. The
change from downtrend to uptrend is marked with a peak on OBV and a price
gap to the upside.
 Figure 9.9: On balance volume (OBV)
Source: Chart courtesy of StockCharts.com

The uptrend took off in July with a test in November and December. The
warning signs that the trend was losing strength were found in OBV, which
began declining in mid-September. At this point, it could not be known
whether the end of the uptrend would lead to a downtrend or to
consolidation. As it turned out, price did consolidate through March 2015,
with a price range between $50 and $53. In this instance, the first example of
divergence led to a strong reversal and the second instance warned of the
end to the uptrend, leading to a consolidation trend.

Accumulation/Distribution

The flaw in OBV is that it makes no distinction between large and small price
moves. All are treated the same. Another volume indicator,
accumulation/distribution (A/D) corrects this flaw.
A/D considers the range of price for each session so that the daily change
in the A/D index is adjusted to show bigger moves for bigger price changes
and smaller moves when the price change is slight. This is an excellent
volume indicator for the large numbers of analysts believing that volume
leads price. Using A/D, it is possible to spot reversal before price signals
confirm a change. The divergence between A/D and price is among the
strongest early warnings of a trend ending and about to reverse. A bullish
divergence occurs when the A/D index rises while prices fall. A bearish
divergence is the opposite.

Key Point: The flaw in OBV is corrected in A/D, which adjusts for the size of
price and volume moves in each session.

A/D is calculated by comparing changes in the daily price and multiplying the
result by volume. Each session’s net total is added to or subtracted from the
previous A/D level:

(Close − Open) ÷ (High − Low) x Volume

For example, the chart in Figure 9.10 contains a primary bullish trend that
ended after a large downward gap and an exceptionally big volume spike.
 Figure 9.10: Accumulation/distribution (A/D)
Source: Chart courtesy of StockCharts.com

Divergence in the A/D index began two weeks before this strong reversal. Any
time a volume spike accompanies a price gap, it should not be ignored. In this
case, both the spike and the gap were very large. A/D did not reveal whether a
reversal is a new primary trend or a secondary trend, but it did forecast
reversal in advance of price.
In this case, it turned out that the large drop was a secondary trend. The
primary trend resumed in 2015, reaching a price of $19.50 by March. The
conclusion here is that the long-term primary bullish trend was in effect
throughout the period, but the late October decline was the start of a
secondary trend, signaled well in advance by divergence in A/D.

Money Flow Index

Another volume indicator, money flow index (MFI) uses daily volume to
weight a popular momentum indicator, or relative strength index (see RSI in
Chapter 12). This creates an index reflecting overbought or oversold
conditions. MFI is interesting to analysts because it combines price-related
momentum with the effects of volume.
The index is set to reflect a value between 0 and 100 and assumes that any
index movement above 80 shows an overbought condition and that index
movement below 20 represents an oversold condition. These key reversal
points can be used in trends of any length but tend to be especially useful in
managing short-term volatility and movement of swing trends.
Like A/D, divergence occurs in MFI. A bullish divergence is found when
MFI moves up but price declines. A bearish divergence is the opposite.
However, MFI is just as likely to provide a confirmation of price direction and
is useful for anticipating price movement in the indicated reversal direction
(upward after oversold and downward after overbought).
MFI is calculated in three steps. First, the raw money flow (RMF) is the
average of high price, low price, and closing price for a session, multiplied by
volume:

((High price + Low price + Closing price ) ÷ 3)x Volume = RMF

Next, a money flow ratio (MFR) is calculated. This is the net of positive RMF in
the preceding fourteen sessions divided by negative RMF in the same period.

(P osit ive RMF session ÷ Negat ive RMF sessions) = MFR

The total number of positive and negative sessions is always fourteen in the
standard MFI calculation. The final step in this calculation is to arrive at the
index value between 0 and 100:

100 − (100 ÷ (1 + MFR)) = MFI

Although this index requires three steps, MFI, like most indicators, is
calculated automatically on online charting services. For example, StockChart
s.com calculated the MFI on the chart in Figure 9.11.
 Figure 9.11: Money flow index (MFI)
Source: Chart courtesy of StockCharts.com

On the chart in Figure 9.11, MFI repetitively anticipated short-term price

reaction to the index moving into overbought range and, in one case, into
oversold. The highlighted price declines follow every case of movement,
creating a reliable form of confirmation. However, while these swing trades
performed consistently, additional confirmation is invariably needed before
acting on what MFI reports.

Key Point: MFI is a volume indicator that highlights overbought and oversold
conditions based on both price and volume moves.

For example, focusing on three months of the previous chart between July
and September, the reversal points of MFI were each confirmed by a
candlestick reversal signal as seen in Figure 9.12.
 Figure 9.12: MFI—three months with confirmation
Source: Chart courtesy of StockCharts.com

These are a series of secondary trends, two bearish reacting to overbought

MFI and one bullish reacting to oversold MFI. As the first trend peak was
signaled as overbought in late July, a bearish harami pattern confirmed a
likely reversal, which occurred immediately. This was repeated in mid-
September when the same signal appeared in conjunction with the MFI
overbought signal.
The offsetting bullish reversal occurred in mid-August, when MFI moved
into oversold range. At the same time, a bullish morning star predicted a
bullish reversal. After seven indecisive sessions, price moved strongly higher
for one month.
These confirming signals demonstrate how trends of all lengths (in this
case, secondary trend reversals averaging one month) can be clearly
anticipated by MFI and confirmed by other signals. In this example,
candlestick signals served the purpose of confirming what MFI predicted.
Because both volume and price reversals appeared at the same time, it is not
possible to determine which was a leading indicator and which was a lagging
indicator. However, observed together, they reliably pointed to the timing of
the reversal, helping investors to make their trade decisions at the best
possible moment in the trend.

Chaikin Money Flow

The Chaikin money flow (CMF) indicator is derived from A/D. Developed by
Marc Chaikin, breakouts may be forecast in advance of the price move. This is
an indicator that reflects overbought or oversold conditions based on volume
accumulation.
CMF establishes an index based on a zero middle line and movement
above or below to a maximum of 1.0 or –1.0. If the CMF index moves above
0.20 on the upside, it indicates overbought conditions; if the index moves
below –0.20 on the downside, it produces an oversold condition. However,
unlike the analysis of price alone to develop these signals, CMF fails to adjust
its indicator for gaps. Therefore, a large gap distorts results and leads to the
wrong conclusions. This points out that CMF, like all volume indicators, must
be part of a broader set of signals and confirmation.

Key Point: CMF fine-tunes volume analysis, but a blind spot is in its failure to
adjust its index for price gaps.

CMF is calculated by comparing the day’s high and low prices to opening and
closing prices and then multiplying by volume:

[((close − low) − (high − close)) ÷ (high − low)] x Volume

These calculations are added for twenty-one sessions and then divided by
volume for the same twenty-one sessions. This sets up a range between +1.0
and –1.0. An example of how to analyze CMF is found on Figure 9.13.
The areas in which CMF exceeded 0.20 or –0.20 are highlighted. While
reaction was short term in this long-term primary bullish trend (representing
secondary or swing trends), the last oversold indicator was a forecast that did
come true in 2015. After price rose to the $53 level, it declined to under $44
per share by mid-March 2015.
Although CMF indicates overbought and oversold conditions, the indicator
is not always reliable as a leading indicator. At times, it lags, as in the first two
overbought signals on the chart. When using CMF in conjunction with other
signals, it should be recognized as only one of many possible signals, subject
to confirmation from price-based patterns and indicators.

Figure 9.13: Chaikin money flow (CMF)

Source: Chart courtesy of StockCharts.com

Chaikin Oscillator

Marc Chaikin also devised the Chaikin oscillator, which tracks money flow
using an exponential moving average (EMA) for two time periods. EMA
weighs the later entries more heavily than earlier entries, so the most recent
price and volume have more influence on the outcome.
Although this is calculated automatically for you through free online
charting services like StockCharts.com, the formula reveals how the
components of price and volume are used together to develop this indicator.
The first step in the three-part calculation is to derive the money flow
multiplier (MFM):
 [((close − low) − (high − close)) ÷ (high − low)]x volume = MFM

Next, MFM is added to or subtracted from the A/D line examined earlier in
this chapter:

A/ D + (− )MFM = Adjust ed A/ D

The result is then calculated as EMA on two periods, three and ten days; and
the net is the Chaikin oscillator:

(3-day EMA of a adjust edA/ D) − (10-day EMA of adjust ed A/ D) = Chaikin oscillat or

The value of this oscillator is highest when it points out divergence. Bullish
divergence is found where the oscillator rises as price declines and bearish
divergence occurs when the oscillator declines as prices rise.
An example of bullish divergence is found is Figure 9.14. This includes two
instances in which the Chaikin oscillator anticipates a price rise even as
prices fall.
 Figure 9.14: Chaikin oscillator—bullish divergence
Source: Chart courtesy of StockCharts.com

The first divergence took place in a consolidation trend lasting from upside
breakout in February 2014 to a second breakout in November, a total of nine
months. The decline in April and May was contrary to a rising oscillator
starting in late March. This revealed the likely move to the upside that
followed, although these were all swing trends. In the period following the
charted period, this stock once again moved into a consolidation period
through March 2015.

Key Point: The Chaikin oscillator is especially useful when it reflects divergence
with the price direction.

These patterns contain similarities. The resistance plateaus form at breakout,

and each breakout is accompanied by a volume spike. But even more
important, the breakouts were anticipated by bullish divergence in the
Chaikin oscillator. This points out the value on this indicator when used with
confirming signals in the price patterns.
 An example of bearish divergence is found in Figure 9.15. In this case the
oscillator points to bearish moves even as the stock price breaks through
resistance and continues to rise. It is possible for the divergence to fail and
for price signals to prevail.

Figure 9.15: Chaikin oscillator—bearish divergence

Source: Chart courtesy of StockCharts.com

As support rose in the first six months of this chart, two instances of oscillator
divergence appeared. Even so, the level of resistance and rising support
formed an ascending triangle indicating bullish continuation. As prices broke
through resistance to form new support, yet another divergence signal
appeared in the Chaikin oscillator.
Despite the divergence signals, this stock demonstrated bullish strength. In
fact, support held through March 2015 and a bearish reversal did not
materialize. Like any indicator, the Chaikin oscillator is only one of many
signals, and in this case, divergence was misleading. The three warnings of a
coming downtrend were not realized. Interpretation of these signals also
rests with proximity of the signal to the price levels of resistance or support.
All these divergence signals occurred at mid-range and not at the crucial
levels where reversal is most likely. The breakout above resistance to form a
new support level was further evidence that price was stronger than the
volume signals in this case.

Key Point: With volume indicators, divergence might not always point to the
direction of price contraction, it could also forecast a coming consolidation
trend.

One interpretation of divergence is a signal of consolidation rather than

reversal. This stock moved into a consolidation trend between November
2014 and March 2015, ranging between $60 and $52. However, when
analyzing a chart and spotting divergence, it is impossible to know whether
any of the three possible outcomes will occur (these are reversal,
consolidation, or continuation). The Chaikin oscillator has value but mainly
as a confirmation indicator of other signals.
Volume spikes and indicators provide value on many levels, but like most
trend analysis indicators, they must be confirmed by other related price
patterns. The next chapter explores the trend significance of gaps in many
forms. Although gaps occur frequently, gap patterns are useful for
anticipating trend reversal or continuation.

Endnotes
1 “High-frequency trading has reshaped Wall Street in its image,” March 17, 2017. www. marketwatch.c
om – retrieved September 27, 2018.
2 Geiger, Keri, and San Mamudi. “HFT Firm Fined $1 Million for Manipulating Nasdaq.” Bloomberg at w
ww.bloomberg.com (October 16, 2014).
3 Murphy, John J. The Visual Investor: How to Spot Market Trends. Hoboken, NJ: John Wiley & Sons.
1996, pp. 5153.
Chapter 10
Mind the Gap: When Price Jumps Signal
Change
The gap is one of the strongest price signals found on a stock
chart. It often accompanies reversal or marks the beginning or
end of a trend. It also will be found in many beginnings and
endings of secondary trends within a longer-term primary
trend.
These highly visible signals often are the first attributes
analysts notice on a chart. This is especially true when a large
gap appears, moving price out of range and setting up an
uncertain new level of resistance or support, at least
temporarily. “Because technical analysis has traditionally been
an extremely visual practice, it is easy to understand why early
technicians noticed gaps. Gaps are visually conspicuous on a
price chart.”1

Key Point: Gaps are noticed immediately; they jump out of the
chart, and this explains why so much attention is paid to them.
However, not all gaps are special; they occur often and may
simply be price coincidences.

A gap is the result of one of two events: first, the opening price
of a session is higher than the previous day’s high close or,
second, when the opening price is lower than the previous day’s
low close. At first, it might seem that all gaps will be visible for
this reason, but it is not the case. Many gaps are “hidden”
because the range of trading in the most recent session is
within the range of the previous day (even with the gap
between prior close and current open). This is demonstrated
later in this chapter.
The gap itself is only a part of the strength in gapping price
action. What happens next is equally as important. If price
returns into range, closing the gap, it means that the initiative
of price movement was not strong enough to take hold
(especially when the gap occurs in close proximity to resistance
or support). However, if the gap does not close, it indicates
strength in the direction of the gap, continuing the current
trend or even setting up a successful breakout above resistance
or below support.

The Nature of Gaps

There are many “rules” in technical analysis, not all universal.

For example, some analysts suggest that gaps are valid
indicators only when confirmed by volume. It is true that gaps
and volume spikes go together, but volume by itself is not
always enough of a signal to draw conclusions about what the
gap means. It could be strong retracement, breakout, or just
coincidence. A more accurate rule is that when you find gaps
and volume spikes together and they occur close to resistance
or support, it probably means something important is about to
happen. Even then, independent confirmation in at least one
other signal is crucial.
Confirmation is always required, and this “rule” is more
universal. Gaps and volume are frequent companions in price
charts, and interpretation is not a simple matter. The
combination of independent confirmation and proximity to
resistance or support add confidence to interpreting gaps and
what they mean to the longer-term trend.
One of the reliable tendencies is for gaps to occur as part of a
secondary trend and can be observed setting up the beginning
and the end of that trend. After a concluding gap, the primary
trend resumes. However, at the time the secondary trend
begins, you do not know whether it is a primary trend reversal;
confirmation still must be the ruling force leading to decisions
to trade or wait. Gaps frequently also set up retracement within
a primary or secondary trend, with a gap followed by a very
brief retracement in price.
Gaps also are found as forms of exaggerated and short-term
price movement. For example, immediately after an earnings
surprise, price tends to spike up (for positive surprises) or down
(for negative surprises). The same thing occurs when
management adjusts its guidance for the coming year. Even
when earnings are exactly in line with estimates, if
management reduces its estimates of coming revenues and
earnings, a price spike is likely to occur as a response to the
news.

Key Point: Gaps are seen along with overreaction to surprises,

when earnings exceed or to not meet expectations. These are
likely to self-correct and fill rapidly.

These price spikes tend to last between one and three sessions
before retreating to a less volatile trading range. This is one of
the keys to success in swing trading. The swing trader, acting as
a contrarian, makes a rational decision to trade as soon as the
exaggerated price move occurs, knowing it is most likely to
reverse. In comparison, most traders overreact to the news,
causing the spike and setting up the reverse. The price spike
often is recognized not only by the gain or loss of several points,
but also by the gap, often a large gap in the price. Swing traders
recognize that the larger the gap, the more likely it is to fill
quickly—meaning a price reversal. In this timing right after
earnings or guidance surprises, gaps are most likely to fill. This
reveals that the prevailing trend, either primary or secondary,
will continue once the dust settles around market reaction to
the surprise.
The process of trading on exaggerated price action,
especially after surprises, is known as “fading the market.” The
earnings surprise is one of the few fundamental indicators that
has an immediate impact on the stock’s price. Most
fundamentals (revenue and earnings, working capital, and
dividend announcements) tend to cause a delayed reaction on
the technical side. Other fundamentals that may affect prices
immediately include announcements of mergers and
acquisitions, new product approval or denial (notably in
pharmaceuticals, for example), or a company’s decision to buy
its own shares in the open market, indicating management’s
belief that the current price represents a bargain. When a
company buys its own shares, those shares are retired
permanently as “Treasury Stock” and will not be subject to
dividend payments in the future. This means that the
company’s quarterly dividend payments are reduced by retiring
stock.
Any rules for trading gaps must be observed with caution.
While specific types of gaps occurring after surprises are
reliable, many gaps occur as a matter of course. Gapping price
action is common and with the combination of visible and
hidden gaps, they occur repeatedly, in some stocks several times
per week. The appearance of a gap is only significant if it is
accompanied by a signal or set of signals and occurs close to
resistance or support.

Gaps Filled or Unfilled

The issue of “filling” a gap determines not only the strength and
meaning of the gap itself, but also what will occur next.
Candlestick indicators (gap filled and tasuki gap, which is
unfilled) both are continuation signals. When one of these
signals occurs close to resistance (in an uptrend) or support (in
a downtrend), it indicates that the current trend is likely to
continue.
These indicators need confirmation, however. Even with
strong indicators in the form of gaps filled or unfilled, the signal
itself may be misleading. For example, in Figure 10.1, price
breaks through below support and then evolves into a gap filled
formation at the very bottom.

Figure 10.1: Filled gap

Source: Chart courtesy of StockCharts.com

This gap at mid-October did not meet the requirements for a

bearish gap filled. That would consist of a black session, a
downward gap, another black session, and then a white session
filling the gap. This formation consists of three white sessions.
Even so, the gap does fill normally indicating an upward
reaction. Secondly, it contained a doji with a large lower
shadow (a bullish sign) and a long white session (another
bullish sign). As expected, price moved to its established range.

Key Point: When gaps fill, meaning the gap is later taken up with
a trading range, traders are reassured, especially if directional
signals are part of that pattern.

An interesting development was a second filled gap formation

as price crossed back into range. This gap filled pattern met the
exact criteria for a bullish candlestick: a white session, upside
gap, a second white session, and a black session filling the gap.
Price continued rising after this development. Confirming this
continuation was yet another bullish gap filled following
immediately. When you find two continuation signals in close
proximity such as this, it is an exceptionally strong form of
confirmation.
The need for strong confirmation, especially when price has
broken through support and then returned into range, is a key
element of a strong gapping signal. In this case, the gap was
itself part of the continuation candlestick signal, and it strongly
supported the likelihood of a continuing uptrend.
The unfilled gap also works as a continuation signal.
Candlestick requirements indicate the upside tasuki gap should
consist of a white session, upside gap, a second white session,
and then a black session closing lower (but not filling the gap).
A bearish version is the exact opposite, a black session,
downside gap, a second black session, and then a higher-closing
white session that does not close the gap.
The perfect tasuki gap works as strong confirmation, but this
does not mean that unfilled gaps are failures. Many unfilled
gaps mark either reversal or continuation, and the larger the
gap, the stronger the signal. For example, in Figure 10.2, two
separate and large gaps marked changes in the secondary
trends.

Figure 10.2: Unfilled gap

Source: Chart courtesy of StockCharts.com

The first gap spanned 8 points between consecutive sessions.

This was a huge upside gap. It did not fill and the sessions did
not meet the standards for typical continuation patterns. In
addition, given the preceding downward price movement, there
was not an uptrend to continue, so this form of gap just marked
a change in the trend, a secondary trend development that
ended up lasting three months.
The second gap moved prices in the opposite direction. This
gap also failed to meet the continuation requirements of the
bearish tasuki gap; however, a strong signal appeared, which
was a support-to-resistance flip. This is among the strongest
signals that the gap breaking through support is likely to hold
as the flip takes place.

Gap Up and Gap Down

Gaps occur to the upside as well as to the downside. Generally, a

gap up tends to occur during an uptrend and confirms that
trend and a gap down confirms continuation of a downtrend.
However, these observations are not always true and must be
confirmed with independent signals.

Key Point: Gaps tend to occur in the same direction as price

movement. This is a common pattern, but it does not always
occur in the manner expected. Opposite-moving gaps could
signal reversal.

In candlestick analysis, a gap up is called a rising window and a

gap down is called a falling window. The two sessions (before
and after the gap) may be of either color, but the assumption
remains the same: that gap up is bullish and gap down is
bearish.
The price pattern is not quite that simple in every case. Figur
e 10.3 includes an example of a strongly rising gap of 7 points.
However, price did not react immediately with a bullish move.
Instead, a two-month bearish secondary trend followed, filling
the gap at the end of that downtrend.
 Figure 10.3: Gap up
Source: Chart courtesy of StockCharts.com

The two-month secondary trend is interesting because it

followed such a strong upward gap, normally a bullish signal.
But the bullish move finally occurred after the double bottom,
marking the resumption of the uptrend—two months later. This
delayed reaction emphasizes the point that gaps, even large
gaps, do not set up an immediate “cause and effect” reaction in
price. The signal might be correct, but price might not respond
immediately.
When gaps move through resistance or support, they often
mark the beginning of a new trend with a modified trading
range. Figure 10.4 shows a gap that sets up a secondary
consolidation trend lasting three months.
 Figure 10.4: Gap down
Source: Chart courtesy of StockCharts.com

This consolidation trend began as the 4- gap pointing

downward appeared. Resistance was set just above $72 per
share. The consolidation finally broke out above resistance but
failed with the appearance of another downward gap. This set
up a new resistance move that immediately rose above the
previous level of resistance.
The price action immediately before the 5-point gap reveals
a runaway gap pattern that concluded with an exhaustion gap
ending consolidation and setting up a new bullish trend. Over
the following three months, a new bullish trend succeeded and
reached $80 per share by the end of March 2015.

Common Gaps

Common gaps, also called trading gaps or area gaps, occur so

often that they provide little in the way of useful signals. They
normally are seen during a price move at mid-range. A popular
assumption is that a common gap is likely to be filled, but in
fact when they are part of a fast-moving secondary trend they
often are not filled at all.
 For example, Figure 10.5 provides three sets of recurring
common gaps, all taking place during secondary trends. Of the
ten common gaps shown, only one (second to last) filled.

Figure 10.5: Common gaps

Source: Chart courtesy of StockCharts.com

The period in which these gaps occur, from August through

October, was a longer-term primary consolidation trend. It
appeared to end with the breakout above the $51 per share
price range. However, even though prices trended higher, a
new consolidation trend took over between November 2014
and March 2015, with prices remaining in a range between $59
and $51. During this period of higher price consolidation, the
pattern of repetitive common gaps continued.

Key Point: Common gaps are just that, common. They do not
provide signaling value unless they exist within a bigger signal.

This does not mean that common gaps lack value. In fact, in
situations like this, with extended consolidation patterns over
time, many common gaps act as indicators that the shorter-
term secondary prices are not likely to gain enough strength for
a breakout. On the chart, the first two sets of common gaps
occurred right before the secondary trends concluded, and in
the third set, the common gaps represented a breakout above
the prior consolidation resistance to form the new
consolidation support. The flip indicated that new support
would hold (which it did), but the momentum of this stock was
not strong enough to create a dynamic trend in bullish or
bearish directions.
Common gaps may be viewed as symptoms rather than
signals. The symptoms are of likely continuation in a
consolidation trend in this example. These also may be found in
long-term but very slow-moving primary uptrends or
downtrends. The common gaps may signal coming change if the
space of these gaps expands, so that a series of common gaps
become runaway gaps as the momentum of a trend increases,
signaling some form of change soon.

Hidden Gaps

Another way in which gaps develop is through “hidden gap”

formations. These meet the definition of gaps in the sense that
the closing price of one session gaps to the opening price of the
next session. However, due to an overlap of the day’s trading
range, these are not visible. In the visible gap, space is evident
between sessions. But these are only part of the gap universe. In
fact, gaps are very common and an examination of just about
any price chart reveals this. Hidden gaps may occur frequently.
This is important because gaps often act as signals, even when
they are not immediately visible.
There are six forms of hidden gaps, which are summarized
in Figure 10.6. Note that in each case, the real bodies of the two
sessions always overlap, which shows why these are hidden.

Figure 10.6: Hidden gaps

Source: Chart prepared by the author

While many hidden gaps are also common gaps and

insignificant—especially given their frequency—it is also
possible for a hidden gap to represent a big move. For example,
in Figure 10.7, two instances of hidden gaps representing large
price moves are highlighted.

Figure 10.7: Hidden gaps with big moves

Source: Chart courtesy of StockCharts.com

Putting this price pattern in perspective, the stock was in a long-

term bullish primary trend. In April 2013, the price was in the
$380 range. By December 2013 it had risen to $400. One year
later at the end of 2014, the price was $450. By March 2015, it
had risen to nearly $490.
However, during the four months shown on the chart, the
primary uptrend was interrupted by a bearish secondary trend.
This was marked by two hidden gaps. The first was a decline of
five points, followed by a price move to the downside, and then
a rebound. The second was a stronger gap moving down 8
points and marking the beginning of the six-week secondary
bearish trend.

Key Point: Hidden gaps are not as visible as others because they
are obscured by real bodies of candlesticks. The danger in
ignoring hidden gaps is missing the signal values they provide.

The hidden gaps were initial signals. They were confirmed by

the bearish harami formed by the two sessions involved with
the second hidden gap—a long white followed by a smaller
black session. The long white extended far beyond the range of
the second day, making this an exceptionally strong bearish
signal.
After six weeks, the secondary trend concluded and the
primary bullish trend resumed. The point to this is that the
large downward-moving hidden gaps were important signals.
These are easily missed, however, if an analyst focused only on
the visible forms of a gapping price pattern. This secondary
bearish trend was volatile and the big gaps set up the strength
of the downtrend, even though it lasted only six weeks.

Breakaway Gaps
The breakaway gap occurs as price moves above resistance or
below support. This is the price area where reversal is most
likely to occur. The breakout from a trading range is half of the
likely pattern; the other half is the breakaway gap itself. This
extreme move is likely to reverse and fill, although this does not
always happen immediately.
An example of two secondary trends concluding with
breakaway gaps is shown in Figure 10.8. In both instances, the
gap marked the beginning of reversal.

Figure 10.8: Breakaway gaps

Source: Chart courtesy of StockCharts.com

From July 1 through mid-September, a gradual uptrend was

underway. As price moved through resistance, the breakaway
gap also formed. After this, price retreated into range and then
broke through below support, falling from $28.50 down to
about $23 per share before a new uptrend began.
A second breakaway gap was found toward the end of the
chart as an uncertain resistance level was clearly violated. After
the period shown, the price dipped in late January to a range
between $27.50 and $25. After this, the February to March 2015
period moved into consolidation between $31 and $28.50.
 None of the trends for this company were particularly
strong or long-lasting. In fact, the price range at the beginning
of the chart (between $28 and $26) was similar to the
consolidation range by March 2015, eight months later. This
suggests that the stock was in a long-term primary
consolidation trend with secondary trends moving both above
and below, but with no success in breaking out. These moves,
marked clearly by breakaway gaps, demonstrated that when
the breakaway occurred in close proximity to resistance or
support, reversal was most likely—especially when the trend in
effect was a secondary trend, meaning the reversal returned
price to its established trading range.

Runaway Gaps

Another form of gap is the runaway gap, also called the

measuring gap. This gap normally will be found during
trending movement, often as part of a secondary trend working
against a primary trend. When runaway gaps appear, it might
indicate a short-term move in the indicated direction, which is
likely to revert to the previous or primary trend direction.

Key Point: A runaway gap may be part of a strong evolving

trend, often found in a secondary trend of great momentum but
short duration.

Another type of runaway gap occurs right after price makes a

move and is supported by a strong gapping action, providing
confirmation of a continuation in the new trend. In other
words, runaway gaps can mean many different things and
should be considered based on where they appear and how
strongly they are confirmed.
A sequence of runaway gaps could be caused when several
traders decide to get in on the trend action by buying shares (in
an uptrend) or cutting losses (in a downtrend). The sequence
may also be a correction of a preceding excessive price move.
For example, Figure 10.9 contains a chart with two distinct
areas of runaway gaps, which look different from one another.

Figure 10.9: Runaway gaps

Source: Chart courtesy of StockCharts.com

The first set of runaway gaps takes price above support. The
breakout came after a set of narrow breadth days and not much
of a trend at all. That indicates the breakout was weak. In fact,
after a 6-point decline, prices rebounded and jumped back into
range. This fast upward movement included a series of strong
runaway gaps moving up.
The first series broke through support and the second series
proved the breakout had failed. The longer-term trend was a
consolidation trend, with resistance set firmly at $69 and
support at $60. In 2015, the resistance level fell gradually until it
rested at about $61 by the end of March, with support holding
at $60. So other than the brief breakout below support, this
primary consolidation trend held with the short-lived breakout
characterized by two series of runaway gaps.

Exhaustion Gaps

The exhaustion gap signals that the current trend or price

pattern has lost momentum and is likely to soon reverse. This
pattern is seen repeatedly in charts. Generally, exhaustion gaps
showing up at the end of a strong trend tend to lead to equally
strong reversals; and the larger the gap, the more likely the
reversal will occur soon in a filling action.
Figure 10.10 contains four examples of exhaustion gaps. This
chart is similar to the one in Figure 10.9 in overall shape and
price pattern; however, the exhaustion gaps clearly defined
turning points in secondary trends.

Figure 10.10: Exhaustion gaps

Source: Chart courtesy of StockCharts.com

As in the previous chart, this one exhibited a long-term

consolidation primary trend that ranged between resistance of
$56 and support close to $50. The first exhaustion gap led to a
test of support, which failed and kept price levels within range.
However, after a strong secondary downtrend in September
and October, prices broke through support. However, that trend
was concluded with another exhaustion gap. The reversal was
confirmed by the session immediately following the gap, which
was a hammer with an exceptionally long lower shadow. The
hammer is a strong single-session reversal. The combination of
the exhaustion gap and the hammer, occurring immediately
after a breakout, raised confidence in the likelihood of reversal.

Key Point: The exhaustion gap forecasts reversal of the current

trend. Once confirmed, this signal should raise confidence to
high levels that a reversal is about to occur.

The next two exhaustion gaps strongly confirmed the likelihood

of continuation in the established consolidation trend. The first
one, in late November, led to a test of resistance; the second
one, in mid-December, led to a test of support. All the secondary
trends on this chart demonstrated the failure of breakouts; and
all these tests were associated with fast and quick secondary
trends and exhaustion gaps.

Island Cluster

A final oddity involving gaps in price patterns is the island

cluster (also called island reversal or archipelago). This is a very
brief set of consecutive sessions with strong gaps on either side.
It is like candlestick patterns such as the abandoned baby,
morning star, evening star, and doji star. In all these signals, a
single session is separated from the sessions before and after by
a gap. However, while all these signals involve an island of one
session, the island cluster contains several, often with a
compressed trading range.
For example, Figure 10.11 revealed a visible island cluster in
July 2014. Price jumped above prior resistance but quickly
returned to the established trading range.

Figure 10.11: Island cluster

Source: Chart courtesy of StockCharts.com

The cluster could predict a strong reversal in which case you

would expect to see prices beginning to move downward. This
did not occur. In this case, the island cluster set up a new
resistance level at $85 per share. Prices settled into a new
consolidation trend lasting until March 2015 with support at
$78. This 7-point range was narrow, considering the range of
the years 2013 and 2014, which was a primary bullish trend
moving prices from $45 up to $85.
Another accompanying signal at the beginning and end of
the island cluster was a set of volume spikes. The first, and
longer one, occurred as prices gapped higher and broke out
above resistance. The second, smaller spike marked the failure
of the breakout and a return into range. However, that rising
bullish range did not endure the preceding breadth of as much
as 10 points. Once the new consolidation trend replaced the
bullish trend, the breadth narrowed to 7 points, with the
change marked by the island cluster and volume spikes.

Ex-Dividend Gaps

Many gaps are mere coincidence. These common gaps are

found often in charts and can easily be misinterpreted. Only
when proximity and price action justify defining a gap as
runaway, breakaway, or exhaustion does the gap matter.
Because gaps are common, they should be analyzed and
interpreted cautiously. Even the appearance of strong gaps
providing signals can be difficult to interpret. Therefore,
confirmation of gaps patterns is just as important for other
forms of price signals. However, some gaps are associated with
specific events and should be analyzed in context.

Key Point: The ex-dividend gap is caused by price adjustment as

dividends are earned. These are non-recurring gaps.

An ex-dividend gap may be found the day before ex-dividend

date or on ex-dividend date itself. This is the date on which an
owner of stock no longer is entitled to earn the current
dividend. The gap is associated with the obligation of the
company to pay the dividend on a specified date soon, usually
within one month. However, because the day before ex-
dividend date is acknowledged as the day the dividend is an
obligation, price of stock may decline to offset the cost of paying
the dividend. The ex-dividend gap may fill or simply work as an
adjustment to a range-bound stock. This gap does not always
occur either, when offsetting supply and demand interests
erase the effects of paying the quarterly dividend.
The danger of the ex-dividend gap is that it may be
misinterpreted by analysts. With awareness that ex-dividend is
arriving, an analyst will discount the downward-moving gap
occurring at or right before that date. It is a mistake to assign
other properties to a gap, such as breakout signal, failing to fill,
or exhaustion. The ex-dividend event distorts price temporarily
and when that includes a gap, even a developing candlestick
signal should be largely ignored. The reversal or continuation
properties of a signal do not necessarily apply when the gap is a
feature of ex-dividend and not of an actual independent price
pattern.
Gaps as Part of Other Signals

Gaps may be located free of other signals. When these signals

occur as breakaway, runaway, or exhaustion signals, they are
powerful initial indicators. Once confirmed, confidence in the
expected outcome will be quite high. However, gaps do not
always exist on their own but may be parts of other signals as
well. Some examples are:
– The engulfing pattern is one of the strongest of two-session
candlesticks. It always sets up with a hidden gap between
the two sessions, with the opening price of the second
session lower (bullish) or higher (bearish) than the previous
day’s close.
– A harami is the opposite of an engulfing, with a long session
followed by a shorter one. It, too, contains a hidden gap
between the two days. A bullish harami gaps up and a
bearish harami gaps down. The same is true of a harami
cross. With a doji in the second day, an upward gap (bullish)
or downward gap (bearish) is part of the formation.
– The morning star and doji star also involve gaps moving
down in a bullish version or up in the bearish version.
– An abandoned baby contains two gaps. In the bullish
version, a downward gap leads to the middle session
followed by an upward gap. In the bearish version the same
pattern emerges but in the opposite direction.
– Side-by-side continuation patterns come in four varieties but
all involve a gap between the first and second day but little
or no gap between days two and three.
– Tasuki gaps and gap filled patterns also act as continuation
patterns. The gap is the essential element in each. In the
bullish continuation, the gap occurs between the first two
 days and moves to the upside. In the bearish version, the gap
takes price lower.

Many candlestick signals involve no gaps whatsoever (three

white soldiers and three black crows, for example). However,
the patterns involving one or more gaps provide the strongest
reversal or confirmation signals. When finding gaps on a price
chart, you need to decide whether it is a stand-alone signal of
value in predicting price action or part of a candlestick reversal
or continuation signal relying on the gap as part of its
formation.

Key Point: Candlestick signals containing gaps are notable but

the gap does not always add to the strength of the signal. It is
only one attribute worth observing.

Gap Proximity to Resistance or Support

Most price signals contain the strongest predictive value when

they occur at or close to resistance or support. This proximity
factor is the strongest factor in determining the reliability of the
signal itself. This is especially true in the case of breakaway and
exhaustion gaps.
When price gaps through resistance or support, a reversal is
most likely. The tendency for gaps to fill should not be
overlooked in any case, but when the gap takes price over the
trading range border, it has extra meaning. A breakaway gap, if
confirmed by a strong signal indicating continuation, is
strongest when it breaks through. However, if a reversal signal
or set of signals occurs immediately, then expect price to retreat
into range.
 Exhaustion gaps occur at or near the end of a current trend,
especially in secondary or swing trends. If the exhaustion gap
takes price through resistance or support, it means a reversal is
highly possible and that price is expected to fill the gap and
return to the established range. Gaps may also signal the end of
a trend with one of two results: reversal to a trend going in the
opposite direction or replacement of the prior trend with a new
consolidation trend. In both cases, duration can not be known
based on the strength of the gap, but the gap itself reveals that
exhaustion (another name for lost momentum) is the clear
signal that the trend will not continue.
These unknown factors related to how price acts after a gap
is found define the technical “gap risk” of chart analysis.
However, this risk is more closely associated with swing trends
than with secondary or primary trends. In a swing trend,
expect rapid movement of price and with exhaustion gaps
anticipate volume spikes. This pattern often recurs within the
swing trend movement of price patterns and provides reliable
signals of short-term changes. However, gap risk applies to all
forms of gaps. Gaps, in general, represent a form of chaotic
price change. In a completely orderly market you would expect
a session’s price to start where the previous session ended. This
is unrealistic, however, as virtually every chart reveals.
Instances of prices opening where the prior session closed are
rare.
For example, Figure 10.12 reveals the likely occurrence of
sessions opening where a prior session closed. Out of sixty-four
sessions, price opened where the previous session ended only
four times. This is typical of how price changes between
consecutive daily sessions.
 Figure 10.12: Inter-session gaps
Source: Chart courtesy of StockCharts.com

This is not a volatile chart. In fact, it represents a three-month

primary uptrend that moves only modestly with daily breadth
of trading never exceeding three points. Even so, the likelihood
of prices opening and closing at the same level is small. This
makes an important point: most gaps, both hidden and visible,
do not contain meaning on their own. It is the gap forming as
part of a strong candlestick signal, or a notable breakaway or
exhaustion gap, that forecasts price changes. When it comes to
gaps, look for the exceptions: gaps moving through resistance
or support (breakaway) or those forming near the end of a
trend (exhaustion).

Key Point: Among the strongest of signals, both reversal and

continuation, are those occurring as price gaps through
resistance or support.

Gap risk is constant. If defined as the risk that price level will
change between sessions, it is found on almost every stock
chart and with great frequency. When gaps are extreme,
however, it invariably signals a strong adjustment to follow that
either indicates a new trend is beginning, or that the gap itself
will be filled by a reversing price move and price will then
return to the previous breadth of trading. This occurs in cases
of earnings surprises, changes in announced guidance, product
news, mergers and acquisitions, and other information, either
positive or negative, that comes as an unexpected event.
Gaps are so frequent that the biggest challenge in
interpretation is not deciding whether the gap has occurred but
distinguishing between normal patterns and exceptions. The
study of gaps demands judgment, an understanding of their
proximity, and how they act as part of two- or three-session
candlestick signals.
The next chapter takes a look at another type of indicator
that is always present, but which provides numerous signals
based on how price moves. The moving average by itself is not
always significant, but when two moving averages of different
duration are studied together, the chart takes on a stronger
forecasting characteristic.

Endnotes
1 Dahlquist, Julie, and Richard J. Bauer. Technical Analysis of Gaps: Identifying
Profitable Gaps for Trading. Upper Saddle River, NJ: FT Press, 2012. p. 1.
Chapter 11
Moving Averages: Order in the Change
The moving average (MA) is a statistical tool that evens out a set
of values. On a stock chart, those values are based on closing
prices over a range of sessions. In reviewing a chart for a
volatile stock, it often is difficult to determine the general trend
of price; with moving averages it becomes possible to tell not
only the direction, but the level of volatility as well. A “moving”
average is just that: with the close of each new session, the
oldest session is dropped off and replaced with the newest
session’s closing price.
With price data smoothing through MA, charting is given a
specific structure not always available otherwise. The longer
the period in the MA, the less responsive it is to change. Newer
information that departs from the average will not change the
MA line as much as it does in a shorter time frame MA. For
example, a fifty-day MA will be more responsive to new
information than a two hundred-day MA. This observation
explains the technical value of MA analysis: by comparing two
different MA lines over a price chart, conclusions can be
reached based on how the two MA lines interact, converge, or
cross, providing signals or confirmation about direction and
potential reversal.

Key Point: The longer the period of the MA, the less responsive
it is to changing prices. This points out the value of two MAs
used together.
The most popular MA system is the fifty-session and two
hundred-session combined analysis. This is based on a simple
moving average (SMA) as the default position, meaning the
calculation is straightforward and not adjusted. The formula for
SMA is:

1 2 3
(v + v + v + .....vn) ÷ n = SMA

In this formula, v represents each value (closing price), and n

represents the total number of closing prices studied in the MA.
For fifty sessions, a combination of fifty most recent closing
prices are added together and divided by 50. For two hundred
sessions, a total of two hundred closing prices are added and
then divided by 200. Fortunately for the trader, online charting
services like StockCharts.com calculate MA automatically as
part of the chart.
Other MA systems weigh the latest information in the belief
that it is more relevant to the current price than older
information. The most popular of these weighted average
systems is the exponential moving average (EMA). While EMA is
used in many technical calculations, especially momentum
oscillators, the system for MA analysis normally is SMA.
Averages can be weighted in other ways as well. For
example, double weight can be given to the latest entry in the
field. For example, a ten-session study adds the latest value
twice, and the added total is divided by 11.
MA in trend analysis provides several benefits. Beyond
reversal signals and confirmation, MA provides examples of
divergence that anticipate a secondary trend moving in
opposite direction from the primary trend and MA also
confirms dynamic resistance and support on many charts,
adding strength to the tracking of a trend and revealing the
moment when the trend begins to weaken (as MA crosses into
the price range, for example).
Considering that MA merely represents the averaging of
price, it is a form of price confirmation itself. However, the
properties of MA have succeeded and have been critically
studied for reliability: “MA rules are very widely used by
practitioners and . . . are one of the few technical trading rules
that are statistically well defined.”1
The skepticism toward MA as a reliable signal for
confirmation is understandable. However, the studies point to
consistent levels of predictability. One study examined:
prices for the Financial Times Industrial Ordinary Index (FTI) over a 59.5-year
period from 1935 to 1994 . . . [and employed] two of the simplest and most popular
classes of technical trading rules—moving average and trading range breakout
rules . . . these technical trading rules have predictive ability if sufficiently long
series of data are considered.2

Given the conclusions of this and other studies, it makes sense

to put aside skepticism and to treat MA analysis as one of the
many worthwhile forms of signal and confirmation. A related
use of MA based on price and price averages involves the study
of momentum oscillators (see Chapter 12).
MAs have one significant drawback. Because they
summarize past information, they are lagging indicators.
Statistically, lagging indicators tend to lack predictive properties
because past price performance can not accurately predict
what the future holds. However, by combining two separate MA
lines and comparing these to price, predictive signals do evolve
and provide value. Crossover and convergence work even
when using these lagging indicators.
Two Moving Averages

The use of a fifty-day and two hundred-day moving average

provides many signals of value in trend analysis; even as a
combination of lagging indicators, using this two-part analytical
tool has widespread acceptance for confirmation. In fact,
“moving averages are considered as more profitable technical
trading rules by analysts. . . . The 50- and 200-day ones provide
the most reliable signals.”3

Key Point: The MA analysis consists of observed lagging

indicators; thus, as confirmation for other signals, MA is a strong
signal for trend analysis.

The aspects of MA in analysis, specifically the significance of

crossover, makes this is strong set of signals. MA crossover
occurs whenever the fast MA (fifty-day) crosses over the slow
MA (two hundred-day). An example of the two-MA chart is
shown in Figure 11.1.

Figure 11.1: Two moving averages

Source: Chart courtesy of StockCharts.com
The fast MA line on the chart in Figure 11.1 was lighter and the
slow MA line was darker. Crossover occurred so frequently that
by itself, it did not provide enough information to generate a
trade. Confirmation is required, and MA often acts as a
confirming signal to other indicators. On this chart, the price
pattern moved rapidly, so MA crossover would most likely be
used for secondary trend identification. Following the strong
uptrend in the first eight months of 2013, the remaining
fourteen months of the chart developed into a primary
consolidation trend between $110 and $90. Crossover did not
take the price permanently above or below this level, but it did
mark the start of a secondary trend from the downward gap in
November 2013 through mid-February 2014. The bearish
crossover confirmed what the gap predicted. The second
example of crossover was late June 2014 and it did not lead to a
big price move even though the crossover was bullish. This
indicator lagged behind the fast price pattern during most of
June.
Even though the two-MA system provides useful information
about price direction or, in some cases, divergence between
price and MA, it is only one part of the broader price pattern. Its
overall weakness (due to its tendency to lag behind price) is one
reason additional signals are needed to time trades accurately.
As a price indicator, how reliable can an MA be? Stronger
signals involve developing price patterns or momentum or
interaction between price and other signals such as volume. MA
is a pattern indicator confirming other signals, but it is best
used with skepticism and only when strongly confirmed by
other independent signals.
The chart in Figure 11.1 reveals the basic “rule” about
crossover. When the slow MA crosses above the fast MA, the
tendency is bullish; this is called a “golden cross.” When the
slow MA crosses below the fast MA, it is a bearish sign. This has
the dramatic name, “death cross.” However, assuming
confirmation is located, MA provides confidence with this
“rule” about crossover direction: “Under [the moving average
rule], technical analysts initiate buy and sell decisions after
comparing the short-run moving average of the share price
with its long-run moving counterpart.”4
The lag impact varies for each MA. The longer the period
studied, the greater the lag. Therefore the two hundred-MA is
referred to as the “slow” MA. However, the value in comparison
is based on crossover itself. The crossover between the two MA
lines is part of the story; price crossover of trading above or
below both MA lines is equally important, predicting price
reaction to follow quickly.

Key Point: The trend analysis value in MA is not in the duration

of the average itself but in how and when crossover takes place.

Bollinger Bands

Although the two hundred-MA and fifty-MA represent a strong

signal methodology, it is not the only way that MA is used in
trend analysis. Bollinger Bands is one effective use of multiple
moving average analysis, based on the SMA method.
Bollinger Bands sets up a statistical summary of price range
and movement. The middle band is a twenty-day SMA. The
upper and lower bands are two standard deviations removed
from this middle band. Therefore, the distance between the
middle band and the outer bands is always identical on each
side. This three-band system sets up several potential reversal
signals while tracking trends over time. Testing price volatility
is only one aspect of the band system. This also indicates
movement above and below expected breadth, which signals
likely reversal points. However, like most indicators, strong
confirmation is essential:
Bollinger Bands (BB) are not standalone indicators as they do not generate explicit
buy or sell signals and are generally used to provide a form of guideline,
indicating possible trend reversals. In this case, if the current price breaks
through the lower Bollinger Band it is considered a buy signal, while if it breaks
through the upper band it is considered a sell signal.5

When price volatility increases, reversal becomes likely. This

tendency is made visual with Bollinger Bands. The bands
increase as volatility increases and contracts as it decreases.
Well-known signal effects are the M tops and W bottoms (see Ch
apter 2), which strongly mark reversal points. Closely
associated with double tops and bottoms, the M top and W
bottom are given additional strength when occurring as part of
Bollinger Bands. When occurring within the band pattern, the
double tops and bottoms extend over a greater time, but the
reversal signal may also be much stronger than upper or lower
shadow spikes taking place over two consecutive sessions.

Key Point: As prices spike above or below Bollinger Bands, the

MA significance for reversal is exceptionally strong.

Another important signal obtained from analysis of Bollinger

Bands is the timing of price spikes above the upper band or
below the lower band. These take on two characteristics. The
most common is a price spike outside the band zone that occurs
right before short-term price reversal. This is a useful
confirmation signal for swing trends. The second, less frequent
type is the price spike occurring in conjunction with a price
gap, often signaling continuation over the short term and a
second band move after the gap occurred. For example, Figure
11.2 contains examples of both types of Bollinger Band moves.

Figure 11.2: Bollinger Band moves

Source: Chart courtesy of StockCharts.com

The highlighted areas in Figure 11.2 reveal fourteen instances

in which the price spiked above or below the band ranges.
Three of these followed the pattern of move-gap-move, or price
moves along with gaps, after which price continued in the same
direction as the price move (above Bollinger Bands) and gap
and then a second move of price above the upper band. Eight
moves were reversals pointed to a coming bullish or bearish
move taking the price back into range within the upper and
lower bands.

Convergence

A phenomenon of MA is the trend-related convergence pattern.

This occurs when the two MA lines narrow and become closely
aligned. It generates a reversal signal and, if confirmed by
related patterns, may be among the strongest applications of
MA.
 Convergence as part of a different set of indicators is aligned
with the opposite of divergence and studied as part of EMA
analysis of momentum. This is explored in Chapter 12. For the
purposes of MA analysis, convergence is based on movement in
the two SMA trends, fast and slow.
The chart in Figure 11.3 shows how this works. Convergence
is strong in this example because it is confirmed by two other
reversal signals.

Figure 11.3: Convergence

Source: Chart courtesy of StockCharts.com

The two lines began converging in April and became closest to

one another in late May. When this occurs, it often is
accompanied by wedge formations. The symmetrical wedge
was marked on the chart. At the end of the wedge—the point
where the two MA lines converged as well—the reversal was
signaled strongly by the bullish engulfing indicator. By itself,
this small engulfing indicator was not especially strong, but
coming at the end of the wedge and at the point of narrowest
convergence of the two MA lines, it forecasted the reversal that
followed.
Divergence

In the case of MA trend analysis, divergence is not the opposite

of convergence. Chapter 12 examines convergence and
divergence relating to momentum; divergence when analyzing
MA is defined as opposite price movement compared to what
MA forecasts.

Key Point: Convergence of the two MA lines anticipates

crossover and possible reversal.

A price crossover (movement of price above or below both MA

lines) is considered a strong signal. For example, in Figure 11.4
a move in price below both MA lines implied a bearish price
move. However, as soon as this occurred, price began moving
in a bullish trend direction.

Figure 11.4: Divergence

Source: Chart courtesy of StockCharts.com

Price crossover is not the same as crossover between the two

MA lines. Once price moves below both lines, as it did on the
chart in Figure 11.4, it is thought to lead MA in the same
direction. What started out as a downtrend was expected to
continue, but it did not. This divergence between price and
proximity (of price to MA) may be a confusing matter for
analysts. However, the conclusive sign of lost bearish
momentum was seen in the mid-May doji session with an
exceptionally long lower shadow. This indicated a likely bullish
reversal, notably as price levels moved back into the MA range
and then moved strongly above both MA lines.

Price Crossover

The value of MA is that it establishes a recognizable trading

range over time. This range—the current trend—is not only
easily identified, but once price evolves above or below, it
creates a specific signal moving away from the established
trend.
A bullish signal results from current price crossing above
both MA lines, and a bearish signal is found when price crosses
below both MA lines. The rationale makes sense for secondary
and swing trades; but for primary trends, price crossover may
mark the beginning and end of a secondary trend as well. Thus,
MA tracked over a long period is useful in determining the
longevity of the trend, whereas short-term crossover can be
used to spot and time shorter-term trends, notably swing
trends. The crossover “rule” is worth acknowledging, given the
ability to find confirmation as well:
In the simplest form, a MA crossover rule operates on the assumption that buy
signals are generated when the current stock price crosses its moving average
from below while sell signals are generated when the stock price crosses its
moving average from above. The rationale for this interpretation is that a trend is
said to have emerged when the stock price penetrates the moving average.
Specifically, an upward (bullish) trend emerges when the price rises above its
 moving average, while a downward (bearish) trend emerges when the price falls
below its moving average.6

The price crossover is especially interesting to observe when

it moves from the extreme of one side and then to the other—
trending first above and then below the two MA lines (or vice
versa). This price pattern volatility represents a momentum
shift, helping with short-term trade timing and potentially
marking the start and stop times of secondary trends. When a
secondary trend first appears, it is impossible to know what will
occur next. Will the new trend emerge as a reversal and the
start of a new primary trend? Or will it truly be restricted to a
secondary move, with a return to the previous primary trend?

Key Point: Price crossover moving from one side of MA to the

other may indicate a momentum shift but could also represent a
confusing set of signals.

This is where price crossover provides insight. Once the

crossover emerges, it becomes a new primary trend only if it
can hold onto its new direction. However, if price reverses
again and moves across the MA lines in the opposite direction,
it is most likely that the prior primary trend will then continue.
This pattern is seen in the chart in Figure 11.5. It begins with
a seventeen-month primary trend, during which price remains
above both MA lines for the first twelve months before it begins
moving below the fast MA.
 Figure 11.5: Price crossover, bullish
Source: Chart courtesy of StockCharts.com

The primary bull trend dominated the chart until the

downtrend began in early June 2014. At this point, price first
moved between the two MA lines and then gapped below at the
point of a bearish MA crossover (fast MA crossed below slow
MA). The resulting downtrend continued at that point,
concluding in October; this trend lasted only five months. The
reversal point moved from below both MA lines to gap above in
December. This identified the secondary trend with high
confidence that the primary trend would continue.
In fact, a bullish MA crossover occurred in mid-January and
price continued rising to nearly $9 per share by March 2015.
This signaled that the previously established primary bullish
trend was continuing. The five-month downtrend was a
secondary trend and analysis of the price crossover patterns
confirmed this.
A bearish crossover works in the same manner. The switch
from price movement above both MA lines (as a signal of a
bearish move to follow) is likely to be followed by a bearish
trend. The next chart in Figure 11.6 provides one example of
this type of signal.
 Figure 11.6: Price crossover, bearish
Source: Chart courtesy of StockCharts.com

The first signal of a bear trend to come was located between

late April and late May, when price moved strongly above both
MA lines. Price immediately fell below both lines by June and
then consolidated until late August. After this, a strong
downtrend began. Price fell rapidly and reached as low as
nearly $5 per share by March 2015.

Key Point: Although price crossover is a strong signal, it remains

a lagging indicator and therefore should be used not as an initial
signal but as confirmation.

It could be argued that the fall in price below both MA lines

was a bullish signal, but there is a subtle difference. In the
initial bearish signal, price exceeded range while MA lines had
converged. The bearish signal was strong. However, once a
strong downtrend began and took off strongly in September,
prices fell so rapidly that MA lagged behind, with the space
between MA and price widening. This was not a momentary
move of price away from MA but an indication of the
momentum of the downtrend. An analysis of the April–May
price crossover above MA, and the price levels below MA lines
from September onward, revealed the difference. One was
clearly a signal while the other augmented MA’s tendency to lag
behind price (especially the slow MA).

MA Double Crossover

Whenever one MA line crosses another, it is referred to as a

double crossover. This signals the beginning of a new trend or
confirms a reversal signal occurring at the same time or
immediately before.
A bullish crossover is created when the fast MA crosses
above the slow MA. A bearish crossover occurs when the fast
MA crosses below the slow MA. Both forms of the double
crossover are lagging indicators, so they will work as
confirming signals rather than as initial reversal signals.
An example of the double crossover forming as a bullish
signal is seen in the chart in Figure 11.7. Although the
downtrend preceding this was not long in duration or very
strong, three things occurred at the same time. First was a
convergence of the MA lines between late January and late
March. Second was a whipsaw consisting of a bearish double
crossover followed immediately by a bullish crossover. Third
was the movement of price from above both MA lines, to below,
and then back to above; a strong bullish move leading to
continued uptrend for the next three months. The strength of
the uptrend appeared in the fact that price remained above
both MA lines throughout the period.
 Figure 11.7: Double crossover, bullish
Source: Chart courtesy of StockCharts.com

In this case, the bullish crossover was especially strong,

consisting of ten consecutive white candlestick sessions at the
point of final crossover. If resistance was marked at the $54
level, prices went through a breakout in late April. If resistance
was marked earlier at $56.50, the bullish breakout occurred in
mid-June. In either case, the primary trend clearly was bullish,
with the double crossover signals confirmed by the breakout
above resistance.
The bearish double crossover is the opposite of a bullish one,
with the fast MA crossing below the slow MA. For example, in Fi
gure 11.8, the fast MA declined rapidly from January through
mid-March when it crossed below the slow MA. This signaled a
bearish sentiment and the crossover point marked the
beginning of that new primary bear trend.
 Figure 11.8: Double crossover, bearish
Source: Chart courtesy of StockCharts.com

The chart in Figure 11.8 was also marked by a set of repetitive

price gaps. The January gap preceded the double crossover; the
March gap occurred immediately after. In early August, the gap
was an exhaustion gap signaling the end of the downtrend and
the start of a new consolidation trend. The early November gap
moved price below the fast MA but did not move much lower.
The consolidation trend lasted until the end of January 2015,
after which a new uptrend began, moving price from $42 to $60
in two months.

Key Point: MA crossover may occur as part of the immediate

trend, but when excessive price gapping is also present, it might
indicate increased volatility and less certainty.

On the chart in Figure 11.8, the double crossover was framed by

price gaps, first downward and then upward, and identified a
point where the six-month downtrend began. The consolidation
at the end of the chart spanned only 4 points, and this narrow
breadth held until the strong bullish breakout in February 2015.
Resistance and Support

An added benefit to MA is that it often strengthens the analysis

of trends by providing additional confirmation of resistance or
support. These levels are normally associated with price alone,
but when price and MA track the same level, it indicates
continuation of the trend. Until price crosses below both MA
lines (in an uptrend) or above both MA lines (in a downtrend),
the trend remains in effect.
This does not mean that MA becomes resistance or support.
Those levels are strictly marked by current prices. However, the
fact that MA might track resistance or support closely confirms
the strength in the current breadth of trading and makes
continuation of the trend more likely than in a situation in
which MA does not track resistance or support as closely.
An example of MA tracking resistance is shown in Figure 11.
9. Price moved downward strongly enough to maintain its
position below both MA lines for the entire six months, with
only brief moves above the fast MA line, followed by immediate
retreat.

Figure 11.9: MA as resistance

Source: Chart courtesy of StockCharts.com
The large downward gap in mid-June could be a reversal signal;
however, it is important to acknowledge that the entire chart
reflects a primary downtrend. Before identifying any signal as a
change in a primary trend, significant confirmation was a
requirement. This development at the conclusion of the chart
was uncertain, and this pattern should be watched to discover
whether the downtrend would continue, move into
consolidation or reverse.
MA also tracks support during uptrends. The fast MA is the
most likely tracking average in most instances. However, in the
chart in Figure 11.10, both MA lines provided a tracking feature
—the fast MA remained close to price range while the slow MA
remained lower but evolved in a pattern of consistent
movement, looking very much like a trendline.

Figure 11.10: MA as support

Source: Chart courtesy of StockCharts.com

The closeness of the fast MA to price was the strongest attribute

of this chart. The minor retreats below fast MA returned to
range quickly. One reason for the close tracking of both MA
lines was the exceptionally narrow breadth of trading
throughout these two years. The range remained in a 2-point
range most of the time during these two years, accounting for
the close tracking of the fast MA and price and for the
consistent rise of the slow MA and close tracking between the
two. The price space between the two MA lines remained below
4 points for the entire two years, making this a bullish primary
trend with low volatility.

Key Point: When both MA lines remain close to other another, it

confirms that the narrow breadth of price will continue—at least
until the MA lines begin to diverge.

MA analysis must be undertaken with caution because these

are lagging indicators. Even instances of divergence occur
mainly as a lagging confirmation signal for other signals. A
second use of MA is applied in momentum oscillators. The next
chapter demonstrates how trend analysis is strengthened by
comparing price with momentum.

Endnotes
1 Neftçi, S. “Naïve Trading Rules in Financial Markets and Wiener-Kolmogorov
Prediction Theory: A Study of Technical Analysis.” Journal of Business, 64 (1991): 549–
71.
2 Hudson, R., M. Dempsey, and K. Keasey. “A Note on the Weak Form Efficiency of
Capital Markets: The Application of Simple Technical Trading Rules to UK Stock
Prices - 1935 to 1994.” Journal of Banking and Finance, 20 (1996): 1121–32.
3 Bigalow, Stephen W. and David Elliot. “Day-Trading with Candlesticks and Moving
Averages.” Futures (2004): 40–42.
4 Gunasekarage, Abeyratna, and David M. Power. “The Profitability of Moving
Average Trading Rules in South Asian Stock Markets.” Emerging Markets Review, 2,
issue 1 (March, 2001): 17–33.
5 Senthamarai Kannan, P., M. Sailapathi Sekar, M. Sathik, and P. Arumugam.
“Financial Stock Market Forecast Using Data Mining Techniques” (Proceedings of the
International MultiConference of Engineers and Computer Scientists, 2010, Vol. I).
6 Fong, Wai Mun, and Lawrence H. M. Yong. “Chasing Trends: Recursive Moving
Average Trading Rules and Internet Stocks.” Journal of Empirical Finance, 12, issue 1
(January 2005): 43–76.
Chapter 12
Momentum Oscillators: Duration and
Speed of a Trend
Momentum reveals the character of a trend. It is not an
indicator about price or direction of price movement, but a
measurement of strength and of how that strength increases or
decreases during the trend’s life.
In all statistical analysis, the concept of exhaustion applies.
This means that no trend continues indefinitely. It eventually
will slow down, stop, or reverse. An analysis of price reveals
direction and movement, but momentum is a separate attribute
of price. It defines trends in terms of when or if those trends
move into a range of overbought or oversold. These areas are
measurable and occur when reversal is most likely. An
overbought condition simply means that the price has been
moved too high, too fast and that buying momentum has
become excessive. As a result, the most likely next step will be
for price to reverse and move back within the middle range
measured by momentum. Oversold is the same attribute on the
opposite side. Once a momentum oscillator moves down into the
oversold zone, the next and most likely step is reversal and a
price increase back into the middle zone.

Key Point: Every trend eventually slows down, stops, or reverses.

These changes are measured by momentum oscillators.
This distinction by zone—overbought or oversold versus a
middle zone—is what gives momentum oscillators great value.
In a normal balance between buyers and sellers, the calculated
oscillator will reside in between overbought and oversold. There
will be occasional moves into overbought or oversold, but these
will not last long.
The index created through oscillators is a measurement of
momentum; the oscillator may perform as either a leading or a
lagging indicator. In either case, the three major oscillators
analyzed in this chapter add great value to trend analysis and,
as confirming signals, increase confidence in the conclusions
drawn about the health of the trend.

The Nature of Momentum

Those studying trends realize that every trend has its own
distinct character. Some are very fast and steep, lasting only a
matter of days or weeks. These are swing trends and are the
most common form of trend. Therefore, a part of trend analysis
is the requirement that momentum be identified without
difficulty. In a short-term trend, movement into overbought or
oversold is a valuable signal that it is a swing trend and not a
new secondary or primary trend.
In the moment, it is a challenge deciding whether reversal is
only a retraction to last a few sessions, a swing trend, reversal of
a secondary trend, or the beginning of a new primary trend. A
key to determining the nature of reversal is to track momentum
along with price and volume signals. When the new direction
continues with strength in all the indicators, including
momentum, it is likely that the reversal represented more than
one of those fast retracements or swing trends.
 This is especially applicable when proximity of reversal is at
the proper point for a new and strong trend. This means that
prices have moved through resistance or support and then
reversed strongly; and this likely reversal is at its strongest with
price gaps and volume spikes occurring at the same time. One of
the basic principles of technical analysis is that failed breakout
is likely to create a new trend moving in the opposite direction.
This can include the potential for movement with enough
momentum to break through the other side of the trading range.
A failed move above resistance might easily signal the beginning
of a new primary or secondary bear trend; and the same type of
move below support often marks the beginning of a new
primary or secondary bull trend.

Key Point: The measurement of failure in a breakout is also a

signal of lost momentum—and reversal.

The failed breakout is not a cause of the new trend, and it is not
always a strong signal of a new trend in the opposite direction.
Following breakout, price might only return into range as part of
the existing trend. However, the breakout is significant when
price is analyzed in conjunction with momentum. It is unlikely
that a new trend begins from mid-range with low volume and
the lack of any specific reversal signals. In reviewing past
reversals at the beginning of primary trends, it is most likely
that the signals will be found. Strong primary trends tend to be
predicted with strong reversal signals and, quite often, by many
signals. In many cases, these include a strong move in an
oscillator into the overbought or the oversold range before or
during the formation of a reversal.
This reveals a key principle about momentum. It is not the
same as a price pattern but a summary of the trend’s strength or
weakness. Strong reversals tend to lead to strong trends, and
when momentum indicators report a strong move, this only
adds to the strength of reversal.
An analysis of strength or weakness in price patterns and
corresponding momentum is part of a larger picture within the
science of trend analysis. Prices do not evolve in a vacuum, and
technical moves—price patterns, volume, moving averages and
of course, momentum—are not the cause of trends but
symptoms of a larger reality reflecting supply and demand over
the long term. Trends do not reverse because a technical signal
predicts reversal; those signals are the visual representations of
reversals collectively due to the supply and demand for a
company’s stock, fundamental strength or weakness, news about
a company, earnings predictions and final reports, mergers and
acquisitions, dividend declarations, decisions by institutional
traders to buy or sell large numbers of shares, and the
intangible factors—rumors, hopes, or fears about a company’s
future, its products, competitive position, economic impact in
domestic and geopolitical changes, and other (often unknown)
influences.
All these collective influences on price and on trends
represent what takes place over time. Anticipation of a trend’s
strength and, equally important, of a coming weakened state
and end, are reflected in momentum oscillators. These include
relative strength index (RSI), moving average convergence
divergence (MACD), and the stochastic oscillator.

Relative Strength Index

The relative strength index (RSI) is a momentum oscillator based

on a created index value between 0 and 100. If the oscillator
calculates out to the mid-range, the current trend is not in
danger, but if it moves above 70 the stock is overbought and if it
moves below 30 it is oversold.
This applies to trends of all durations. Swing traders rely on
RSI to track the daily trend and to look for confirmation of
reversal found in price and volume signals. When RSI moves
above 70 or below 30, it tells a trader that the short-term trend is
likely to reverse. For secondary trends, the tracking mechanism
is the same and may signal a return to a primary trend.
However, in using RSI to track primary trends, a move into
overbought or oversold range does not necessarily generate a
trade. Primary trend observers understand that RSI often moves
above 70 or below 30, only to immediately retreat into the
oscillator’s midrange.

Key Point: Moves into overbought or oversold territory signal

potential reversal but do not always require an immediate trade.

RSI becomes significant—notably in tracking of primary trends

—when the oscillator moves into overbought or oversold range
and remains there longer than just a few sessions. It is even
more significant when the oscillator moves further into
overbought or oversold range. The farther it moves, the stronger
the likelihood of a reversal.
The range levels of 70 and 30 are the normal settings for RSI.
These can be adjusted to suit a trading strategy. By moving them
to 80 and 20, for example, occurrences of overbought or
oversold will be reduced; by moving the lines to 60 and 40, RSI
will move into overbought and oversold far more often; but
reliability of the oscillator is also reduced when frequent signals
are located. Therefore, 70 and 30 are applied in most cases to
decide when a stock becomes overbought or oversold.
 In trend analysis, movement into overbought or oversold is
only one way that momentum can be studied. Another involves
the speed of change. If the oscillator is trending rapidly toward
the 70 or 30 lines, it indicates growing momentum and a likely
move into the overbought or oversold area of the index. This is
especially true when price is close to resistance (and RSI is
moving strongly toward 70) or support (and RSI is moving
strongly toward 30).
This “momentum of momentum” is significant because it
reveals growing strength in a specific direction. Contrarian
investors acknowledge that markets tend to overreact to news.
This overreaction is reflected if RSI changes rapidly while
moving in a specific direction with price proximity to resistance
or support also evolving toward potential breakout.
A considerable difference should be acknowledged between
momentum barely moving above 70 or below 30 versus an
extreme move into those zones. The further above 70 or below
30 the indicator moves, the stronger the chances for a corrective
reversal.
Finally, the true deciding point is not whether RSI shows a
move into overbought or oversold, but how long it remains
there. A tendency seen on most stock charts is for RSI to remain
in the middle zone most of the time, with moves above 70 or
below 30 very brief and that correct rapidly. When the RSI
oscillator remains in overbought or oversold status for an
extended period, the signal is that the trend is weak and likely to
stop moving or to reverse.
The best way to appreciate what RSI reveals is to understand
how it is calculated. Even though free charting services calculate
the oscillator as part of a chart, this awareness of what RSI
reflects is likely to improve the skill of trend analysis.
 RSI is calculated over fourteen consecutive sessions. First, all
upward-moving closing prices are added together. The
exponential moving average (EMA) is then calculated. Next, all
downward-moving sessions are added together. The EMA for
this group is then calculated. The upward-closing EMA is divided
by the downward-closing EMA to determine relative strength:

EMA(upward) ÷ EMA (downward) = RS

The index value is derived from RS as a final step:

100 − (100 ÷ (1 + RS)) = RSI

This creates a value between 100 and 0. With the formula in

mind, it makes sense that RSI will normally reside between 70
and 30. Over the most recent fourteen sessions, the net effect of
rising and falling days will tend to revert to the mean so that
moves above 70 or below 30 are the exceptions. Once the index
moves above 70, conditions are overbought and a bearish signal
is given; and once it moves below 30, the oversold condition
produces a bullish signal.

Key Point: Moves above 70 and below 30 in the RSI index are
exceptions; based on how the index is calculated, value is
normally found at midrange.

Given the method for calculating RSI, it makes sense to view

overbought and oversold moves as exceptions. An analysis of a
primary trend over many months reveals that RSI moving into
overbought or oversold is the exception and that most of the
time, RSI will reside between 70 and 30. The chart in Figure 12.1
makes this point.

Figure 12.1: Relative strength index (RSI), primary trend

Source: Chart courtesy of StockCharts.com

The stock in Figure 12.1 was undergoing a gradual bearish

primary trend, which continued beyond the period charted.
With the usual movement quite mild and with small breadth of
trading, RSI did not give out much of a signal in the first two
months. During this period, breadth of trading was
approximately 1 point. Once price levels began falling, however,
the RSI line also trended from a midrange of 50 all the way
down to 30. As a lagging indicator, RSI reflected the changing
sentiment among buyers and sellers; however, the rapid price
decline, even in a primary bear trend, was disturbing because of
its momentum. Once RSI moved below 30 in late September, a
reversal to the upside was expected. This secondary bullish
trend was further predicted by the bullish signal in the form of a
falling wedge between August and September.
 The reversal point was located at the point that RSI moved
well below 30 and a hammer formed. This candlestick reversal
was confirmed by the confirmation signal in the form of a
thrusting lines indicator. As it often occurs, the reversal moved
beyond the established trading range and trended above the
long-term resistance level. RSI went into overbought and
remained there for most of November. This duration was
unusual and served as a leading indicator for a likely return to
the primary bear trend. This was confirmed by the abandoned
baby signal in early December. At this exact point, RSI had also
declined back into midrange.
In this example, RSI confirmed what price movement
revealed and identified the extremes of oversold and
overbought. In the short term, these secondary trend
movements (first a bearish move from September to mid-
October and then a bullish move from mid-October to early
December) were clearly identified and confirmed by RSI. For the
rest of the period charted, RSI resided between 70 and 30.
Another example of RSI involves analysis of secondary
trends. In the chart in Figure 12.2, RSI also marked the start and
end of secondary trends in a long-term consolidation primary
trend.
 Figure 12.2: Relative strength index (RSI), secondary trends
Source: Chart courtesy of StockCharts.com

It appeared that the consolidation trend moved from a range of

$104 to $100 and then to a lower range of $98 to $94. However,
an analysis of what occurred over the period beyond this chart
revealed the true consolidation range was between $104 and
$94, the high of the earlier consolidation and the low of the later
one.
This might be difficult to track without the addition of RSI.
Note that the initial move breaking out below support was
marked by a decline in RSI into oversold. This predicted that the
breakout would not succeed. However, the upward breakout did
succeed after the appearance of the bullish harami and
subsequent upward price gaps.

Key Point: The value in RSI is how its signal is combined with
other reversal signals in gaps, candlesticks, and volume, for
example.
The price breakout quickly moved into overbought. Even though
price levels had moved much higher than previous trading
range, the overbought conditions were accompanied by
sideways price movement with very narrow range of two points
or less. This predicted weakness in the bullish trend and in fact,
three months beyond the period charted, price levels had
returned to the consolidation range between $104 and $94. Even
with secondary trend movement as high at $112, the primary
consolidation trend held.
This chart demonstrated another characteristic of
momentum. Trends often become exhausted and stop with an
expectation of a reversal, but this does not always occur. At
times, momentum reaches a plateau and stops for a period. This
plateau may be brief or extended. After the plateau, often
forming a consolidation trend, the previous dynamic trend may
continue or it may break out and move in the opposite direction.
On this chart, the initial plateau declined to a lower plateau.
This lasted for ten weeks, from August to mid-October. At the
point of breakout, a new uptrend started and moved from $94 to
$112 over the next two months.
The plateau appears to be a pause in momentum, but this is
not the only change in a trend’s behavior. No trend is likely to
continue moving in the same direction without reversal,
retracement, or plateau. In this sense, the plateau marks a
period of settling down when previous momentum stops only to
resume and for the trend to resume or reverse. The plateau is a
critical momentum signal because invariably it, like all
consolidation trends, is going to end. Knowing exactly when is
the difficult part.

Moving Average Convergence Divergence

Whereas RSI provides a readily recognizable single index value,
moving average convergence divergence (MACD) involves three
different moving averages. Its value is in its tracking of an
ongoing trend, in the way it signals that a current trend has
weakened and is coming to an end.
Developed by Gerald Appel in the 1970s, MACD uses its three
“time series” calculations based on the closing price. The first
two are a fast EMA (twelve days of closing prices) and a slow
EMA (twenty-six days of closing prices). Third is a signal line
EMA of the last nine sessions. Several values of MACD include
the divergence between the two EMA lines, the movement of
both EMA signals above or below the signal line, and the degree
of change in the signal line itself, above or below zero. The
overall index value of MACD ranges from +1.00 to –1.00.1
The signals derived from MACD include crossover (when
both averages cross over the signal line and move above
(bullish) or below (bearish)); and divergence (developing and
widening gaps between the two EMA lines). An upward swing is
divergence of a bullish nature and a downward swing or
expansion of the gap is bearish.
An example of MACD in analysis of a primary trend is found
in the chart in Figure 12.3. The steady price movement in this
bullish primary trend explains why the signal line was above 0
for most of the period, but with very little change.
 Figure 12.3: Moving average convergence divergence (MACD), primary
trend
Source: Chart courtesy of StockCharts.com

A more interesting observation is that the two EMA signals

remained far above the signal line through most of the chart. In
fact, the initial crossover in August marked the beginning of the
primary bull trend, continuing until early December. At that
point, both MACD lines started to decline. Although they did
cross into bearish range by moving below the signal line, the
signal was clear. The trend had either paused or ended.
The dip in price and MACD turned out to be a retracement
move only. The bullish side-by-side lines promised continuation.
The fact that the MACD averages remained above the signal line
by the end of the charted period indicated continuation as well.
In fact, three months after the period charted, the primary bull
trend was still in effect.
In this case, MACD tracked the primary trend with strong
consistency. If both EMA lines remained strong above the signal
line, there was no immediate reason to believe the trend was in
any danger. The first retracement (in late September) was
followed quickly by a continuation signal in the form of an
upside tasuki gap. The second retracement (in December) was
more difficult to interpret. Both the twelve- and twenty-six-day
EMA lines declined rapidly. The only assurance of continuation
was the failure of EMA lines to both fall below the signal line,
confirmed by the bullish side-by-side continuation signal at the
end of the chart.

Key Point: One of the strengths in MACD is being able to rely on

trend continuation if both MA lines remain on the same side of
the signal line.

Tracking MACD over a series of faster-moving secondary trends

involves greater volatility in momentum, as you would expect.
The next chart, in Figure 12.4, is a good example of how MACD is
used to identify the all-important turning points in the form of
crossover.
 Figure 12.4: Moving average convergence divergence (MACD), secondary
trends
Source: Chart courtesy of StockCharts.com

The chart in Figure 12.4 is a busy one. On the momentum side,

crossovers were prominent. The first bullish crossover lagged
after the bullish harami at the bottom of the secondary trend.
The subsequent reversal and new secondary bearish trend was
marked by the bearish harami cross; as MACD lines crossed
below the signal line, a bearish harami confirmed further
bearish movement. However, another bullish trend began with
the bullish harami at mid-October. The bullish tasuki gap
continuation signal confirmed this trend at the same time as the
bullish NACD crossover. In December, declining MACD lines
failed to move below the signal line. At the same time, a bullish
side-by-side white lines continuation signal indicated that the
bullish trend was likely to continue.
The fast-moving secondary trends dominated this chart. The
confirmation from MACD crossover added a sense of order
beyond the recurring candlestick signals.
Stochastic Oscillator

The stochastic oscillator combines two moving averages

calculated with high and low prices as well as closing prices
over fourteen consecutive sessions. The term “stochastic” refers
to random probability, appropriately named with the use of two
separate calculations to create an oscillator. The stochastic
oscillator creates value between 0 and 100, with overbought
conditions found above 80 and oversold below 20. In this regard,
the stochastic oscillator is like RSI. It usually is a leading
indicator since it is based partly on high and low price levels.
Thus, for the analysis of some trends (especially primary
trends), it often provides more useful and timely information
than RSI.
The difference between RSI and the stochastic oscillator is in
the method used to find turning points. Stochastic calculation is
a comparison between closing prices and price range. This takes
advantage of a tendency of price itself.
Prices tend to close near the extremes of the recent range just
before turning points. In the case of an uptrend, prices tend to
make higher highs, and the settlement price usually tends to be
in the upper end of that time period’s trading range. When the
momentum starts to slow, the settlement prices will start to
retreat from the upper boundaries of the range, causing the
stochastic indicator to turn down at or before the final price
high.2
The calculation, combining price closings with price ranges,
makes this oscillator more accurate than RSI, especially when
price moves with increasing volatility. The first of two moving
averages is based on fourteen sessions. This is also called the %k
line. It is calculated as:
 100[(cc − lc) ÷ (hh − ll)] = %k

In this formula, cc is the current closing price; lc is the lowest

close of the past fourteen sessions; hh is the highest high; and ll
is the lowest low.

The second moving average is the average of the last three %k

outcomes and is called the %d line:

%k(three most recent sessions) ÷ 3 = %d

The oscillator resulting from these calculations identifies

overbought (above 80) and oversold (below 20) conditions. For
example, the chart in Figure 12.5 represents six months of a
primary bullish trend. However, during this period, secondary
trend movement was marked clearly by the stochastic oscillator
and its overbought and oversold conditions.
 Figure 12.5: Stochastic oscillator, primary trend
Source: Chart courtesy of StockCharts.com

The first secondary trend was identified by the double top,

confirming the overbought signal in the stochastic oscillator. The
two-week price decline concluded as the oscillator fell rapidly
and moved into oversold. At that point, a bullish harami
confirmed a likely reversal and resumption of the primary bull
trend.

Key Point: The stochastic oscillator, like RSI, is based on

identification of overbought and oversold, but it also needs
strong confirmation to generate a trade.

The oscillator remained in overbought from mid-August through

late September, a period of exceptional length. The longer it
remained there, the greater the chances for a bearish reversal.
The piercing lines signaled this as the stochastic oscillator once
again declined. Like the previous decline, this drop was also
rapid and moved into oversold as a double bottom signal
appeared.
The stock was once again marked as overbought from late
October to late November and during the first half of December.
The lagging bearish engulfing confirmed a secondary bearish
trend. However, even with consolidation resulting through mid-
March 2015, the direction of this trend eventually resumed its
bullish movement.
The stochastic oscillator is equally effective at identifying
turning points in secondary trends. Figure 12.6 provides an
example of this.

Figure 12.6: Stochastic oscillator, secondary trends

Source: Chart courtesy of StockCharts.com

In Figure 12.6, the initial three black crows lagged the stochastic
overbought condition. This was followed quickly by three white
crows and then a bearish harami, defining a very fast secondary
bull trend. The resulting bear trend continued for more than a
month, and during this time the oscillator moved into oversold
until the bullish doji star confirmed a likely bullish reversal.
However, the duration of the resulting overbought status, from
late October through late November, was confirmed by the
bearish evening star.
This bearish warning predicted a decline in price. In January,
a large one-session gap of 10 points set up a consolidation range
between $91 and $85, remaining in effect through the end of
March 2015.
The stochastic oscillator, like RSI and MACD, provides
confirmation value and in some instances, leading indication of
coming change. However, while the consistency of momentum
trends is consistent, it cannot reveal the extent of the response
likely to occur. Momentum is the most reliable of timing signals
for trends of all lengths.
The next chapter expands on the observation about
momentum by examining technical volatility of stocks. If
volatility is another word for “risk,” stock charts make risk
highly visible, especially in the extremes of high volatility.

Endnotes
1 Appel, Gerald. Technical Analysis Power Tools for Active Investors. Upper Saddle
River, NJ: FT Press, 2005, p. 166.
2 Person, John L. A Complete Guide to Technical Trading Tactics: How to Profit Using
Pivot Points, Candlesticks & Other Indicators. Hoboken, NJ: John Wiley & Sons, 2004,
pp. 144–45.
Chapter 13
Volatility: Marking Risk within the Trend
The term “volatility” describes unpredictable price movement,
fast directional swings, and overall risk involved with investing.
Volatility is price uncertainty.
Prices can and do move even when volatility is low, and
volatility does not forecast or predict price movement in either
direction. It is a mistake to equate volatility (market risk) with
price movement or its symptoms. In times of high volatility,
risks are greater but so is profit potential. Depending on
whether you are tracking a primary or a secondary trend,
volatility in the trend itself reveals a lot. For a primary trend,
increasing volatility could forecast the end of the trend and for
a secondary trend, volatility often forecasts a quick return to
the primary trend. In swing trends, volatility offers great
opportunity for fast profits if trade timing is made skillfully and
based on strong signals and confirmation.

Key Point: Volatility signals the end or reversal of a trend but not
price direction, or it may reveal uncertainty within the trading
range.

In a consolidation trend of any duration, interim volatility

reveals the inability among both buyers and sellers to move
price beyond the range-bound breadth of trading. However,
when volatility increases within the consolidation trend, it
often signals that a breakout is becoming more likely.
 Typical of this condition is seesaw swings between
resistance and support even as the consolidation continues, at
times for several months or even years. Consolidation is a
frustrating trend for those traders looking for price action or
for investors seeking capital gains. However, if the trading
range is wide enough during consolidation, short-term profits
are possible. The predictability of the trading range adds to the
certainty of trades. In comparison, in a high-momentum bullish
or bearish trend, reversal is less certain and timing of trades
may offer lower degrees of certainty.
These are generalizations about volatility and the entire
matter is uncertain. Any attempt to quantify volatility is going
to be an estimate and cannot clearly define the next price
direction. The best you can hope for is an indication that, once
confirmed, points to dynamic price continuation or change.

Calculating Volatility

A few methods for defining and calculating volatility help

manage trends and spot possible changes in the future.
However, the number of points of a stock’s movement is not a
reliable volatility test. The scaling of a chart determines
volatility as a relative matter. For example, a chart scaled in 1-
point increments and experiencing a 3-point move might be
extremely volatile (based on typical daily price changes).
However, another stock scaled with 10-point increments and
experiencing the same 3-point move might not reflect high
volatility. It could point to low or declining volatility due to the
relative point change in a typical session versus the 3-point
move itself.
Another way to define volatility is to calculate a “breadth test.”
This is a comparison of the fifty-two-week breadth of trading to
the current breadth. For example, if the current breadth is 6
points and the fifty-two-week high/low is $67 to $52, the
breadth test is:

6 ÷ (67 − 52) = 40%

A big problem with this method is that the fifty-two-week

breadth is not the last word in breadth of trading. Several
problems arise, including:
1. Spikes distort the analysis. For example, in a 15-point range
over fifty-two weeks, the “typical” range could be closer to 4
points, with one 11-point price spike. A spike is exceptional
and non-repetitive, and as soon as it appears, price levels
will immediately return to the established breadth. In
removing the spike, the relative impact of a price move is
not the same as when the spike is included. With a smaller
fifty-two-week high/low range, that 6 points of current
breadth of trading is more volatile than with the spike left in
the calculation.

Key Point: The breadth test measures price volatility in one

respect, but it is reliable only if spikes are removed.

2. Trend during the fifty-two weeks will also distort the

conclusion but not the outcome. Whether the breadth test
results in 50.0 percent or 27.3 percent, what does it mean?
Did the high price during the fifty-two weeks occur closer to
the beginning of the year (meaning a primary bearish trend
is in effect)? Or did it occur at the end of the fifty-two weeks
 (meaning a primary bullish trend is in effect)? Did the price
at the end of the year approximate price at the beginning,
with the price level advancing and retreating during the
year? All these patterns contain different meanings and
require different interpretations.
The conclusion you reach based of where high and low
prices occurred is crucially important in defining the
volatility expressed in the current range. This is even more
difficult to quantify if the fifty-two-week breadth involved
numerous swings between high and low, in which case the
current breadth of trading does not indicate the strength or
weakness of the trend, nor a likely direction in the case of
breakout. You might understand the breadth test without
knowing very much about the health of the current or the
next trend.
3. Proximity of current prices in relation to the high/low range
also carries great weight in interpreting breadth as a form of
volatility. Successful reversal is most likely to occur when
price levels are close to resistance or support (successful
breakout is also most likely if confirmed at the same
proximity). The true definition of volatility may need to rely
on the significance of proximity more than on the breadth of
trading.
4. Changes in breadth in recent weeks is revealing in trend
analysis. The trend’s health may be more readily understood
if the breadth of trading has been broadening or narrowing
in recent weeks. In practice, trend analysis relies on changes
or lack of changes in the breadth of trading and not so much
on the breadth test as a definition of the trend’s health.

Volatility Indicator
A statistical test of volatility attempts to quantify volatility by
comparing the latest closing price to the average closing price
based on standard deviation. This will be influenced by the
number of days selected in the test.
This indicator is calculated by finding standard deviation
and dividing it by the average closing price for the same
number of periods:

V = (σ cpn) ÷ (cp ÷ n)

where: V = volatility
σ = standard deviation
cp = closing prices
n = number of periods

This calculation may be performed against n periods of several

days or over several years. It produces a version of volatility
based on one standard deviation; in comparison, Bollinger
Bands accomplishes the same comparison basis but uses two
standard deviations, one above and one below the middle
average. This enables an analyst to spot widening or narrowing
breadth of trading and to anticipate coming changes. For
example, as Bollinger Bands width and price breadth both
narrow within a consolidation trend, it signals a likelihood of a
breakout in the near future.

Key Point: Calculated volatility is a result of applying standard

deviation, but Bollinger Bands is a more accurate test of the
same tendencies within a trend.

The more stringent statistical application of Bollinger Bands

compared to this volatility indicator make the bands approach
a more reliable indicator of trend health and, as a result, of
volatility. The purpose of volatility testing is to spot evolving
risk levels within trends (bullish, bearish, and consolidation)
and to use the technical price patterns developed from
Bollinger Bands to identify volatility and trend strength.

Evolving Volatility Levels

Beyond statistical analysis of volatility and development of

indicators like Bollinger Bands, specific patterns evolve that
reflect growing or shrinking volatility. Whereas Bollinger Bands
may be thought of as a trend-based form of probability matrix,
these changing trend characteristics are more reliable for
anticipating changing volatility.
A broadening price formation signals increasing volatility.
As the breadth of trading expands, so does the likelihood of
other volatile signals, such as price gaps. For example, Figure 1
3.1 shows a breadth of trading broadening over nine months,
from June 2013 through February 2014.

Figure 13.1: Broadening breadth of trading

Source: Chart courtesy of StockCharts.com
In this example, breadth moved from only 2 points up to as
much as 20 points, a strong expansion of breadth, and of
volatility. It is particularly interesting to note that the period
between the end of this broadening formation and the gap near
the end of July, was followed by a return to a narrow breadth.
By the end of March 2015, prices settled into a range between
$82 and $74 as a further phase in this long-term primary bull
trend.
Decreasing breadth takes the form of either a wedge or a
triangle. For determining the significance of each, caution must
be exercised. The difference between wedges and triangles
often is only slight, but the interpretation is opposite. A rising
wedge signals bearish reversal, but an ascending triangle points
to bullish continuation; and a falling wedge is a bullish reversal
signal while a descending triangle indicates bearish
continuation.
In both instances, the decrease in the breadth of trading
signals falling volatility. For example, Figure 13.2 reveals a
chart with a rising wedge over four months, a six-month
consolidation, and a falling wedge lasting nearly three months.
The falling wedge was bullish and was followed by a strong
upward surge in late November.
 Figure 13.2: Narrowing breadth of trading—wedge
Source: Chart courtesy of StockCharts.com

The problem with these wedges is that they can be interpreted

in several ways. For example, the falling wedge could be
interpreted as a descending triangle (bearish) by moving the
support line down to $70 per share. That would have been a
misleading signal, as price settled at a support level of $80
through the three months following the period shown.

Key Point: The similarity between wedges and triangles—and

their opposite interpretation—makes them questionable signals
for reversal timing.

With this uncertainty in mind, wedges are best used to confirm

strong reversal or continuation signals found at the same time,
but not relied upon as particularly strong signals on their own.
However, whether bullish or bearish, the narrowing breadth of
trading reveals a reduction in volatility. In the perspective of a
primary trend, this is valuable information forecasting that big
price moves are not likely soon.
The triangle is stronger than the wedge because it relies on a
flat resistance (ascending) or a flat support (descending). The
longer this flat period, the more reliable the triangle is as a
directional signal and a sign of declining volatility. For example,
Figure 13.3 contains several triangles over two years. This
displays a narrowing of volatility. In the first triangle, breadth
of trading went from approximately 15 points down to about 6.
This breadth held through to the end of the period charted.
However, from October to December volatility appeared to be
increasing.

Figure 13.3: Narrowing breadth of trading—triangle

Source: Chart courtesy of StockCharts.com

After the first two ascending triangles, a descending triangle

(bearish) appeared between August and October. This forecast a
price decline to follow. By the end of March, prices did fall to
settle at under $80 per share. Given the overall breadth of
trading in the last portion of the chart, the price decline
appeared to accompany a secondary trend with low volatility.
Volatility also evolves by changes in the frequency of price
gaps. As gaps begin showing up more often, volatility increases,
and as gaps decline, so does volatility. For example, in Figure 13.
4 a consolidation trend extended from May to the end of the
chart (and beyond to the following March). Within this primary
consolidation trend, numerous secondary trends were
characterized by a growing number of gaps.

Figure 13.4: Increasing gaps

Source: Chart courtesy of StockCharts.com

The gaps appeared in various configurations. The first two

marked an island cluster in October. The third preceded a price
swing. The fourth, fifth, and sixth gaps were small but marked
the approach to resistance without breakout. The final gap was
much larger and approached support before reversing.
All these price swings revealed the strength of the
consolidation trend. None of the swings were able to break
through resistance or support. This demonstrates that even
with high volatility like the kind found on this chart, breakout is
not guaranteed. The volatility affects the secondary trends
without affecting the overall strength of the primary
consolidation trend.
Volatility declines as the frequency of price gaps declines. In
Figure 13.5, an example of this pattern is summarized.
 Figure 13.5: Decreasing gaps
Source: Chart courtesy of StockCharts.com

Over a six-month period, only three visible gaps worth noting

were identified. Several hidden and smaller gaps were not
highlighted as they were common gaps and had no specific
signal value. The pattern involved 5 points of breadth over the
period, but the key observation is that throughout the period,
resistance held—until it broke in late December.
Although price retreated temporarily, the breakout forecast
a successful breakout and a bullish move in price by March to
approximately $57 per share. This marked two important
changes: volatility declined through the period and the
breakout marked a new bull trend. Whether it was primary or
secondary was not established until March, but the direction
and decrease in volatility were clear.

Key Point: Declining volatility associated with post-breakout

periods confirms the likelihood of success in the newly-
established trading range.

A third way in which volatility is labeled as increasing or

decreasing is in the volume trend. While volume may spike or
move according to specific volume indicators, increases or
decreases in typical volume mark changes in volatility.
Increasing volume equals greater price volatility, and
decreasing volume indicates reduced volatility. As the volume
level evolves, it is likely that changes in breadth of trading will
be found as well. An example of increasing volume is shown in
Figure 13.6.

Figure 13.6: Increasing volume

Source: Chart courtesy of StockCharts.com

Before the price decline starting in October, the breadth of

trading was quite narrow at about 1 point. However, volume
levels had been increasing since early July, culminating at the
first price decline through mid-October. At that point, breadth
of trading grew to approximately 4 points. A second decline
between late November and mid-December saw a continuation
of increasing volume and expansion in breadth of trading to 10
points.
 The chart in Figure 13.6 reveals the close relationship
between increasing volume and growing breadth of trading.
Together, these provide a picture of growing volatility that
continued beyond the period shown. This major oil company
was in a primary bearish trend during a period when oil prices
fell from over $100 per barrel to under $50. This made the
bearish primary trend not surprising, but the condition of the
decline was laid out in the combined pattern of increasing
volume and broadening breadth of trading.
Decreasing volume reveals reduced volatility and may not
reveal as clear a change in the breadth of trading as the
opposite, increasing volume pattern. This is so because
decreasing volume tends to hold breadth of trading to a very
narrow span. If the period starts out with a narrow range, the
span is less likely to become narrower and more likely to
remain consistent even if price moves substantially higher or
lower. For example, in Figure 13.7, the price doubled over two
years, but over the last fourteen months volume levels decline.
At the same time, breadth of trading maintained an average of 5
points, increasing at times to as much as 10 points due to
retracements or secondary trends. However, the primary
bullish trend was consistent throughout the two years.
 Figure 13.7: Decreasing volume
Source: Chart courtesy of StockCharts.com

A recurring set of retracements is reassuring in a chart like this.

No one expects a primary trend to move in the same direction
without pause over two years. Retracements reflect both profit
taking and testing of momentum. However, in this example, the
pattern of bullish price movement with decreasing volume
revealed falling volatility.

Average True Range

The use of average true range (ATR) does identify volatility.

However, it can be adjusted so that selection of ranges and
dates may easily create a desired result. ATR should be used as
a comparative indicator to confirm other signals. ATR was
developed in the late 1970s by J. Welles Wilder to demonstrate
how growing and shrinking breadth of trading is reflected in
volatility.1
Key Point: ATR can be modified to create a desired result.
Confirmation bias should be kept in mind when using this
indicator.

The indicator points to a high likelihood of volatility at price

tops and bottoms in a manner like momentum indicators such
as RSI. The assumption with ATR is that when the index is mid-
range, volatility is low. The analysis is usually performed over
fourteen consecutive days. There are many ways to define true
range, which is the starting point for calculating the index.
Three examples of true range—high minus low, prior close
minus low, and current high minus previous close—are
summarized in Figure 13.8.

Figure 13.8: Types of true range

Source: Prepared by the author

Because true range is the result of the greater of these three

choices or selection of others, it reflects a range of trading
breadth for a specified period. By itself, true range may give off
an artificial perception of volatility; however, when studied as
an index of fourteen periods, it reports the trend toward
increasing or decreasing volatility and a comparison to
proximity of price.
 An example of ATR compared with ranging price versus
peaks and how these are reflected on ATR, is shown in Figure 1
3.9.

Figure 13.9: Average true range (ATR)

Source: Chart courtesy of StockCharts.com

When price was ranging (adhering to established breadth of

trading), volatility was expected to be low, and this clearly was
established by comparing the price pattern to ATR. However,
once price became dynamic in either a bullish or bearish move,
volatility was expected to increase dramatically. In this
example, price bottomed out in mid-October after a three-week
decline and bottomed once again in mid-December following a
two-week decline. In both instances, volatility as measured by
ATR peaked as well.
ATR is a relative indicator, meaning its strength as a test of
volatility is based on behavior of the index next to price
behavior. Notice, for example, the extreme rise in the ATR index
in the last week of October, corresponding to the large black
candle session at the same time. This reflected the
corresponding price to calculated ATR as a factor of the change,
but it also demonstrated a characteristic of volatility: it moved
based on the degree of change in price, regardless of price
direction. For example, at the end of the chart, price breadth
narrowed in the last two weeks, but ATR had not returned to
the low levels established in the first two months of the chart.
This indicated that while volatility had declined, it was not as
low as it was at the beginning of the period.

Volatility According to the VIX

A final measurement of volatility worth mentioning is the

Chicago Boards Option Exchange (CBOE) volatility index, or VIX.
The VIX tracks the speed of index option change among the
S&P 500 index of stocks. It produces a weighted average of
estimated volatility. It is also called the “fear index” as it reflects
investor nervousness about price levels in the S&P 100,
meaning movement in the VIX reflects overall volatility.
However, VIX is removed from direct volatility in stocks. It
measures the implied volatility of options rather than directly
tracking stocks. The concept of a financial index measuring
stock index volatility was first proposed in 1989.2

Key Point: The VIX measures volatility in the moment, but

because volatility moves quickly, it is only one of several volatility
indicators worth tracking.

Based on the introduction of an index-based measurement of

market volatility, CBOE hired Vanderbilt University professor
Robert Whaley to develop a practical volatility index based on
options implied volatility. The result was the VIX, which is used
by many investors to time trades, especially trades within swing
trends.3
Trend analysis must consider the volatility in price to judge
the trend itself. Recognizing that volatility increases and
decreases over time defines the finite life of every trend.
However, volatility does not imply reversal or price direction;
and prices may move, even strongly, in a bullish or bearish
direction or as a consolidation trend, in times of both high and
low volatility. This demonstrates the point that price movement,
momentum and volatility are all attributes of trends, but
lacking price patterns and specific reversal indicators, changes
in volatility do not forecast changes in the trend. Volatility (risk)
is a component of investing, and as it changes, so do the risks
and opportunities of holding positions in a stock.
The next chapter moves trend analysis out of the realm of
the technical and shows how fundamental volatility ultimately
affects stock trends. This does not always occur immediately,
but fundamental volatility is one of many aspects that technical
analysts should track. By being aware of how fundamental
trends behave, some assumptions concerning future price
movement can be made with a reasonable expectation of
accuracy.

Endnotes
1 Wilder, J. Welles Jr. New Concepts in Technical Trading Systems. Greensboro, NC:
Trend Research, 1978, pp. 22–24.
2 Brenner, Menachem, and Dan Fand Galai. “New Financial Instruments for Hedging
Changes in Volatility.” Financial Analysts Journal (July/August 1989) http://people.ster
n.nyu.edu/mbrenner/research/FAJ_articleon_Volatility_Der.pdf.
3 Whaley, Robert E. “Derivatives on Market Volatility: Hedging Tools Long Overdue.”
Journal of Derivatives 1 (Fall, 1993): 71–84.
Chapter 14
Fundamentals: Connecting the Two Sides
Some investors favor the technical approach for selecting stocks
and timing trades, while others rely solely on the fundamental
approach. Both contain merits as well as setbacks. However,
using both in combination improves overall information,
reduces market risks, and adds to the chances for profits from
well-selected and well-timed trades.
Another point is worth mentioning: companies with strong
fundamentals tend to also experience equally strong growth in
stock value. This makes sense. The more profitable a company
becomes and the more it increases the value of equity, the more
valuable its share price. Although this might become apparent
only over the long term and not immediately, it is also true for
analysis of secondary trends within the longer-term primary
trend. Consistent fundamental trends are more likely to be
reflected in equally strong price trends, lower stock price
volatility, and reduced market risk.

Key Point: The connection between strong fundamentals and

strong stock performance points to the advantage of using both
types of indicators to pick stocks and for tracking long-term
trends.

This chapter examines a few select fundamentals for four

different companies. The fundamentals are dividend per share
and payout ratio, P/E ratio, revenue and earnings, and debt to
total capitalization ratio.

Value Versus Growth

Most trend analysts focus closely on price trends as if they

occur in a vacuum. Assigning momentum to supply and
demand is legitimate, but that supply and demand interaction
results not only from perceptions of market value in a stock,
but also in the fundamental success (profitability) of a company,
changes in dividends paid and payout ratio, and effective
management of working capital. These collectively form the
essence of fundamental analysis and define companies as value
investments or growth investments.
For technical investors deciding between value or growth, a
problem becomes evident upon historical analysis. In some
years, value investments outperform and in others the
dominant force is growth. Neither side consistently
outperforms the other. In selecting companies as investment
candidates, a starting point is to examine fundamental
indicators and trends over time, look for consistent growth and
profits, and apply wise selection criteria to pick stocks whose
fundamental trends support the resulting technical trends.
The concept of value investing, developed by Graham and
Dodd, points to undervalued securities as potential bargains, or
“value investments.” These value investments often are traded
at levels well below market value of similar securities, and in
extreme cases may approach or even move below tangible book
value per share.1
A “growth” investment must be defined as one perceived to
report higher success in terms of profits and market share over
a period of years. Thus, investors in growth stocks expect to
earn higher returns but also must accept higher market risks. A
value investment is believed to be set at a bargain price, often
measured by the price/earnings (P/E) ratio. Since the single
number called the P/E is the result of a technical value (price)
dividend by a fundamental value (earnings), it is a hybrid
indicator. As a rule, a moderate P/E is best when it resides
somewhere between 10 and 25 (so that the current price per
share is equal to the profits to be earned in ten to twenty-five
years). This multiple is how value investments are defined.
Value investors seek bargains, meaning lower P/E stocks.
Growth investors are likely to pick stocks with higher P/E in the
belief that greater multiples reflect greater potential for growth.
P/E is best analyzed in terms of annual range from high to low
rather than as a fixed value in time. Analysts look for low
volatility in the year-to-year P/E range, seeking the ideal of
range between 10 and 25 consistently.
These generalizations do not provide specific guidance in
stock selection. For this, it makes sense to begin with an
analysis of fundamental volatility over several years. Those
companies whose selected fundamentals are strong and
improving—and with little volatility in the fundamental trend—
will also tend to be strong technical trending stocks. This is the
premise for starting with fundamental analysis as a comparison
point for technical trend analysis.

Key Point: A short list of key fundamental indicators helps pick

stocks with strong value or growth potential.

The Concept of Fundamental Volatility

Most investors understand technical volatility quite well. It is
the tendency for price to trend in predictable or unpredictable
ways. A high-volatility stock has greater market risks than a
low-volatility stock. For many, trend analysis is the study of
technical volatility. However, it is also possible to estimate the
likelihood of technical volatility by first determining the status
of a few fundamentals and to draw conclusions about
fundamental volatility—and how that level of volatility is likely
to be reflected in trend predictability on the technical side.
The meaning of fundamental “volatility” is similar to most
forms of trend analysis. A strong fundamental trend will
include growing revenues and earnings, strong dividends per
share, medium-range P/E ratio, and steady or declining debt to
total capitalization ratio. However, just as technical volatility
becomes meaningful as it moves through time, fundamental
volatility must be studied with a few key points in mind:
1. What matters is the trend and not just status. Is the trend
reflective of improvement or decline? Are ratios improving
or falling off? In the analysis of fundamental trends,
spotting changes (improvement or decline) over many
years is revealing, whereas a review of only the latest fiscal
year’s results does not provide any information concerning
the trend itself.
2. The dollar values do not always tell you everything you
need to know because so many fundamental trends rely on
comparative ratios as well. Once you have the numbers for
a period of years, some relationships (notably revenue in
relation to earnings) must be studied in terms of how net
return has changed over the period and not just changes in
dollar values.
3. The trend is only a starting point in a more detailed overall
analysis. Fundamental trends may not reflect what is going
 on with a company today, so changes like mergers and
acquisitions, new product announcements, and a
replacement management team, are less tangible
fundamental influences that might affect next year’s results
but are not reflected in the historical fundamental trend.

Key Point: Fundamental volatility identifies a form of risk that

carries over to the technical side as well.

Dividend per Share and Increased Dividends

A starting point in quantifying fundamentals is an analysis of

the dividend trend. Dividend analysis involves several
components and is not as simple as it seems at first glance. As
one analyst states, “the harder we look at the dividends picture,
the more it seems like a puzzle, with pieces that just do not fit
together.”2 This refers to the complexity of how dividends affect
corporate cash flow as well as investor perception of a stock’s
value; some discount the value of dividends while others view
them as a major determinant in stock selection. The realm of
dividend policies and payments does define fundamental value,
and dividend trends should be analyzed carefully as part of the
selection process.
There are three specific tests worth performing to quantify
the fundamental trend in terms of dividends:
1. Dividends per share is the annual dollar value of dividends,
usually paid quarterly. For example, a $1 per share dividend
(or $100 per 100 shares owned) is likely to be paid at the rate
of twenty-five cents per quarter. The analysis of dividends
per share is focused on whether dividends declared and
paid rises remains level or falls each year. The more times a
 dividend is increased, the greater the positive outcome.
Companies whose dividend is raised every year for ten years
or more are defined as “dividend achievers.” This
designation was created by Mergent, Inc. in 2003.3
2. The trend in payout ratio defines even further the value of
dividends. The payout ratio is the percentage of reported net
earnings paid in dividends. This must be limited to a
maximum of 100 percent for practical reasons, but many
companies pay only a small portion of earnings in dividends.
A positive payout ratio is at the very least steady over many
years, and it is even better if the ratio grows over time.
However, stockholders expecting dividends also must
acknowledge the value of retaining a portion of earnings to
fund other activities whether defined as expanding into new
territories and products, acquiring capital assets, retiring
debt, or funding acquisitions.
Payments of dividends and increases, as measured by the
payout ratio, play a key role in defining the value of a
company and its stock:
Companies that have a long-standing history of stable dividend payouts
would be negatively affected by lowering or omitting dividend distributions.
These companies would be positively affected by increasing dividend payouts
or making additional payouts of the same dividends. Furthermore, companies
without a dividend history are generally viewed favorably when they declare
new dividends.4

The payout ratio clarifies increased dividend payments each

year by disclosing whether the dollar amount keeps up with
earnings. For example, it is possible to discover dividend
growth every year along with a decrease in the payout ratio,
a signal that the company has reduced its dividends in terms
of the percentage of earnings returned to shareholders. With
rapid market expansion, companies are likely to rely
 increasingly on long-term debt, so growth in the debt to total
capitalization ratio does not always mean there is a
problem.5
Payout ratio and dividends paid per share are best
reviewed in conjunction with the reported debt to total
capitalization ratio (the portion of capitalization represented
by long-term debt). If all the dividend ratios (dividend per
share, dividend increases, payout ratio, dividend yield) are
positive but long-term debt has also risen, is one a substitute
for the other? If dividend fundamentals are positive at the
expense of shifting equity into debt, it means that future
earnings will have to be increasingly used for debt service,
meaning there will be a diminishing level of earnings
available to fund dividends.

Key Point: Analysis of dividend-related trends is complete only

when reviewed along with the trend in the debt to total
capitalization ratio.

For example, over an eight-year period, Verizon (VZ)

increased its dividends every year, which appeared positive
at first glance. However, when that increase is viewed along
with the negative increase in the debt to total capitalization
ratio, the overall picture is quite negative. This relationship
is summarized in Table 14.1.

Table 14.1: Dividends per share and debt to total capitalization ratio, Verizon (VZ)

Fiscal Year Dividend per share Debt/cap ratio

2010 1.93 32.4
2011 1.98 35.7
2012 2.03 34.6
2013 2.09 47.4
 2014 2.16 87.1
2015 2.23 80.9
2016 2.29 79.8
2017 2.33 70.3

Source: CFRA Stock Reports

When there is no actual growth in terms of revenue and

earnings, but positive dividend trends are offset by negative
debt to total capitalization ratio growth, the practical
realities of using debt to fund growth do not apply. In the
case of Verizon, revenue grew over the period, but earnings
were erratic. Net return (earnings divided by revenue) grew
from 2.4 percent in 2010 to 23.9 percent in 2017. To a degree,
increased revenue and impressive net increase in net return
could justify the increased debt to total capitalization ratio.
However, the end of 2017 level of 70.3 translates to an
overall increase in long-term debt. Total capitalization was
funded 70.3 percent by long-term debt by 2017, meaning
only 29.7 percent was derived from shareholders’ equity.
Given the erratic net earnings and negative trend in the debt
to total capitalization ratio, the slight increases in dividends
per share might not be justified over the long term. Investors
might justifiably be concerned about such imbalanced
dependence on long-term debt and what that means for
future cash management. In this situation, increased
dividends are of minimal value and increased long-term
debt reflects a negative fundamental trend.
3. Dividend yield is yet another key element of dividend
fundamentals, but it may also lead to inaccurate conclusions.
The reported yield at any given moment is derived by
dividing the annual dividend per share by the current stock
price. Consequently, dividend yield rises as the stock price
 falls and declines as the stock price rises. Due to this
mathematical reality, an investor should calculate dividend
yield based on the actual purchase price and consistently
use that yield rather than the yield that changes with an
evolving price level.
This points out yet another problem of perception. An
investor noting a sizable increase in dividend yield might be
tempted to invest immediately. This is especially true if the
initial stock selection criteria includes seeking higher than
average dividend yield. However, the yield will increase not
only due to declarations of higher dividends but also
because of strongly declining stock prices. Before assuming
dividend yield reveals the entire story, the reasons behind
the higher yield should be examined. If the fundamental
news about a company is negative, the investment value is
negative, not positive. For example, a company on the verge
of declaring bankruptcy or being investigated for filing false
financial statements with regulators is likely to see a decline
in price per share and a corresponding increase in dividend
yield.
Once an investor has purchased shares, the dividend
yield is fixed to the rate applicable to the share price. This
does not change even as the price per share moves, even
significantly. Even so, many investors track dividend yield as
closely as price per share and may even assume that as the
yield grows or shrinks, it affects their yield; it does not. The
basis for calculating dividend yield is the price paid per
share and the dividend paid per share.

P/E Ratio
A second indicator is the price/earnings (P/E) ratio. This is the
multiple derived by dividing price per share by earnings per
share. The result, called the multiple, represents the number of
years of earnings reflected in the current price per share.
The medium level between 25 and 10 is generally assumed
to be reasonable for stocks. However, the true meaning of P/E is
not restricted to a multiple in the moment. What is meaningful
is the breadth of yearly P/E range from high to low and the
consistency of that range over many years. In a fundamentally
volatile trend, P/E may range broadly, spiking high in some
years and settling low in others. In a low-volatility company, P/E
is likely to be far more consistent over several years.

Key Point: In studying P/E, two methods should be used: the

annual range from high to low and the trend in that range over
time.

P/E most often is used to define stocks as bargain-priced (with

low P/E) or as overpriced (with high P/E). This analysis,
however, is best applied between companies in the same
industry, as many market factors beyond the generalized
assumptions about the “right” P/E level can vary due to the
dissimilar attributes of one industry compared to another.6
The reason for analyzing P/E by range and by time is that P/E
in the moment is not reliable. An annual range and multiyear
trend provides a strong indication of fundamental volatility.
The P/E as a single indicator at any given time involves two
factors with different time frames. Price changes constantly and
is current; earnings are fixed as of the latest financial quarter
or fiscal year (and may also be modified based on independent
audit). Thus, the earnings side may be several months out of
date. The ramifications of this disparity include a possibility
that cyclical and seasonal changes in some industries will make
today’s P/E unreliable. However, by reviewing several years of
range in P/E, the picture is clarified.

Revenue and Earnings

The study of revenue and earnings, perhaps more than any

other fundamental indicator, defines fundamental volatility. In
a low-volatility company, three attributes are expected:
consistently rising revenue, consistently rising profits, and level
or increasing net return.
The combination of all three of these features is essential to
understand the health of a company’s fundamentals. When
revenue and earnings are declining and even moving into the
range of net losses, the trends clearly are negative. However, a
hidden negative pattern may also be found. This occurs when
revenues are on the rise and earnings are flat or declining. At
the same time, net return is falling. This means that earnings
reflect a growing decline as a percentage of revenues.
For example, an eight-year analysis of McDonald’s revenue
and earnings reveals growth in the top line in only three of the
eight years, with earnings inconsistent in the same period. Net
return increased in five of those eight years. This is
summarized in Table 14.2.

Table 14.2: Revenues and earnings, eight years, McDonald’s (MCD)

Source: CFRA Stock Reports

To some extent, this negative relationship between revenue and

earnings reflects a market plateau for the company and does
not necessarily foretell a decline in the value of the company.
However, the fundamentals were reflected in the stock price. At
the beginning of 2010, the stock was valued in the mid-$40s, by
October 2018 value had peaked at just over $168 per share.
Between 2013 and the first quarter of 2015, the stock had
moved into a primary consolidation trend with breadth range-
bound between $85 and $100 per share.
This technical trend occurred even as both revenue and net
profits declined. However, by the end of 2015, the stock moved
into a strong bullish trend and all growth occurred from 2016
through 2018.

Key Point: Rising revenues can be misleading; if the net return

declines as revenues rise, the overall fundamental trend is
negative.

The negative relationship expressed in the net return of

earnings to revenues is only one of many factors in
fundamental trend analysis. In the example above, the
consolidation primary trend could represent a supply and
demand pause that will be followed by a new bullish primary
trend in future quarters and years. The range of net yield
between a high of 20.5 percent in 2010 and 22.8 percent in 2017
represents moderate growth in percentage terms, even with
significant growth in price per share.
During the same period, other fundamentals for MCD were
positive. Dividends per share rose each year from 2.26 in 2010
up to 4.64 in 2017 and the payout ratio moved from 49 percent
to 59 percent. At the same time, debt to total capitalization ratio
increased from 44.0 to 112.4.
The fundamental trends were mixed. This example
demonstrates the importance of reviewing the whole picture,
not only a small portion of it. Given the relatively small span of
net return over the five years in the context of other
fundamental trends, MCD reported overall positive
fundamentals except for the troubling debt to capitalization
ratio, which was above 100 percent by the end of the period.

Debt to Total Capitalization Ratio

Debt to total capitalization ratio compares sources of total

capitalization used by an organization. Dividing long-term debt
by shareholders’ equity produces a percentage, which is
expressed as a numerical value (usually to one decimal place)
and without percentage signs.
Beyond comparing these two sources of capitalization, the
value of this ratio is found in tracking it over time. When a
company’s debt to total capitalization ratio remains steady or
declines, it is a positive trend. However, when it increases each
year, it reveals a negative trend. As a company relies more and
more on long-term debt, the corresponding debt service of the
future must increase. This means that future earnings will have
to be dedicated more to debt service and less to funding growth
or paying dividends.7

Key Point: A growing debt to total capitalization ratio points to

working capital problems in the future, when higher debt service
will reduce expansion and dividends for stockholders.

This is a key fundamental trend because it reveals so much

about management’s policies. When dividends per share and
dividend payout ratio both increase every year but are offset by
ever-higher debt to total capitalization ratio, it means the
company cannot afford to pay dividends from higher earnings.
Instead, those positive dividend trends are offset by negative
debt trends.
Debt analysis often is overlooked in fundamental analysis
with a greater focus on the income statement, and specifically
on revenue and earnings trends. In analysis of working capital,
emphasis often is placed on the current ratio, which is derived
by dividing current assets by current liabilities. However,
current ratio is also easily controlled, even in periods when a
company is losing money. With the ideal current ratio between
1.0 and 2.0, as cash flow deteriorates, it is easy to keep the
current ratio in positive territory by increasing long-term debt.
Because the current ratio is concerned only with current
liabilities, these growing long-term debts are not considered in
this analysis. Unfortunately, the current ratio presents only part
of the greater picture.
For example, a comparison of current ratio and debt to total
capitalization ratio for JC Penney (JCP) over eight years reveals
what would appear to be a safe current ratio level. But debt to
total capitalization moved from 36.7 to 70.1 by 2017, a period
with falling annual revenue and earnings—with most years
reporting net losses. These trends are summarized in Table
14.3.

Table 14.3: Fundamental trends, JC Penney (JCP)

Source: CFRA Stock Reports

This summary reveals the true overall fundamental trend. It is

not realistic to point to current ratio as “proof” of sound
management over working capital. Given the offsetting 91
percent increase in the debt to total capitalization ratio (from
36.7 up to 70.1) and declining revenue and earnings, the current
ratio does not reflect what was taking place during this period.
The analysis of several key factors such as this also shows
that fundamental analysis cannot be performed on limited
trends but must include all the relevant trends underway.
However, for technical trend analysis, the larger question is: Do
fundamental trends end up reflected in the price history of the
stock? In the case of JC Penney, the answer was yes. From 2010
through 2011, the stock was trading in a primary consolidation
trend, range bound between $37 and $18 per share. Between
2012 and 2014, a bearish primary trend prevailed, with stock
prices declining from a high of $43 down to a low of $6 per
share. This remained in consolidation through 2016, with price
ending at $8 per share. By September 2018, price had dropped
to under $2 per share.

Comparing Fundamental Trends to Technical Trends

The ultimate test of fundamental trend analysis is how it

becomes reflected on stock charts. In fact, a consistent “cause
and effect” is found between the two sides. Companies with
strong fundamentals tend to also demonstrate bullish stock
price trends and those with weak fundamentals tend to report
bearish trends.

Key Point: Fundamental trends ultimately will play out in price

trends, but this does not always occur immediately.

This cause and effect becomes true over time, but the actual
cause and effect is distorted by marketwide trends. For
example, when the market (as measured by index movement
such as the DJIA or S&P 500) is moving in a direction, individual
stocks tend to exhibit a similar directional bias. Equally
impacting technical trends are sector-specific economics. For
example, when oil prices fell rapidly in 2014 and 2015, Exxon-
Mobil (XOM), the largest US oil company, saw its shared decline
from $103 down to $84 per share. The effect of lower oil prices
was reflected both in fundamental and technical outcomes for
the company.
 Apart from the relatively short-term economic and
marketwide impacts on a stock’s value, longer-term
relationships between fundamental and technical trends are
quite clear. A series of fundamental trends are the starting
points for this comparison. Figure 14.1 provides a five-year
summary of dividends and the revenue/earnings history for
Wells Fargo (WFC).
Figure 14.1: Wells Fargo—fundamentals, eight years
Source: Prepared by author from CFRA Stock Reports
On the dividends side, both dividends per share and the payout
ratio grew during this period. At the same time, revenue was
erratic but net earnings continued rising. This was overall a
very positive result for the eight-year period.
Another positive outcome was reported by Verizon (VZ), as
shown in Figure 14.2.
 Figure 14.2: Verizon—fundamentals, eight years
Source: Prepared by author from CFRA Stock Reports

Dividends per share increased gradually while the payout ratio

was erratic. At the same time, revenues rose consistently while
earnings did not move much. This was also a positive outcome
with less impressive earnings growth.
 On the negative side, Big Lots (BIG) reported the most
troubling of fundamental trends: rising revenue with falling net
earnings, as shown in Figure 14.3. Earnings finally began
moving upward toward the end of the period.

Figure 14.3: Big Lots—fundamentals, eight years

Source: Prepared by author from CFRA Stock Reports

Overall, the reported dollar value of both revenue and earnings

were both low in comparison to Wells Fargo and Verizon.
Another negative outcome was experienced by Canon (CAJ).
Dividends were paid only for part of the period. However, the
decline in both revenue and earnings through 2017 told the
story of the fundamental trend; it reversed to the positive side
in the last two years This is shown in Figure 14.4.
 Figure 14.4: Canon—fundamentals, eight years
Source: Prepared by author from CFRA Stock Reports

Although dividends rose per share over two years and the
payout ratio climbed above 80 percent, the examination of the
five-year history of revenue and earnings pointed to a troubling
negative trend. Both fell substantially. Concerns for potential
investors would involve not only a desire to see improvement
in the income side, hoping for a turnaround and positive
change, but also a revised policy involving dividends and the
payout ratio. It could make greater sense for the company to
use its earnings to increase market share and seek profitable
expansion and to suspend these high dividend payout levels
until the revenue and earnings outlook improved.

Key Point: The relationship between revenues and earnings on

one side, and dividend trends on the other, is complex. In some
cases, it makes sense to reduce the dividend trend in favor of
long-term growth and expansion.

A final examination of the fundamentals is an eight-year

examination of the debt to total capitalization ratio. This is
summarized in Figure 14.5.
 Figure 14.5: Debt to total capitalization ratio
Source: Prepared by author from CFRA Stock Reports

Of these four companies, only Verizon and Wells Fargo reported

debt to total capitalization ratio for all five years. Both trends
were negative, rising through the eight years.
The analysis next compares the fundamental trends to stock
charts for the same period. Wells Fargo’s five-year chart
consisted on a consolidation trend for years 2010 and 2011 and
then a strong bullish primary trend from 2012 through 2015,
with prices rising strongly in all three years, trending from a
low of $22 per share up to a high of $55. The positive move
continued slightly through to 2017. When other fundamentals
are examined next to the price chart, the relationship between
fundamental and technical trends is clear (see Figure 14.6).
 Figure 14.6: Wells Fargo—eight years
Source: Chart courtesy of StockCharts.com

The Verizon chart moved in a different manner—bullish to

consolidation—as revealed in Figure 14.7.

Figure 14.7: Verizon—eight years

Source: Chart courtesy of StockCharts.com

In Figure 14.7, the first three years moved in a bullish primary

trend from a low of $17.50 up to a high of $42.50 per share. This
reflected the steady growth in revenue levels but appeared to
not react to lack of growth in earnings. However, from mid-
2013 through late 2018, a primary consolidation trend replaced
the bullish move, with prices range-bound between $37.50 and
$51.
A completely different stock chart for eight years was
discovered for Big Lots, which is found in Figure 14.8.

Figure 14.8: Big Lots—eight years

Source: Chart courtesy of StockCharts.com

Big Lots experienced flat revenue and falling earnings results

during this period. The stock chart was extremely volatile for
the entire period, with prices ranging between $58 and $22
with big price swings of 10 points or more in both directions
and with swings taking place over average time spans of two
months. This might make Big Lots a good candidate for swing
trading, given the fast movement of swing trends and lack of
any permanent primary or secondary trends beyond this
exceptionally volatile outcome. Does the price history reflect a
reaction to the fundamental trend? To a degree it does. Revenue
was flat, but earnings fell. In addition, the dollar value of
earnings was so low that the fundamentals were chronically
weak.
Key Point: Weak fundamentals are likely to be reflected in
declining price or worse, in price volatility.

The fourth company, Canon, also demonstrated how weak

fundamentals translate to weak technical trends. Figure 14.9
summarizes their price history for eight years.

Figure 14.9: Canon—eight years

Source: Chart courtesy of StockCharts.com

Revenues and earnings both fell during much of this period.

The decline was consistent, making the fundamental trend
evident in a deteriorating set of results. This was reflected as
well in a decline in stock price from over $50 per share at the
start of 2011, down to prices as low as $28 at the end of 2017,
followed by a 2018 rally to as high as $39.
A clear correlation between fundamental and technical
trends is likely to occur. Over a long-term period, such as eight
years, the history of change in key fundamentals does reveal
that, despite interim marketwide and economic forces, the
fundamentals lead the technical levels consistently.
In the next chapter, the examination of attributes making up
trends are put together to shown how specific types of trend
signals work collectively to forecast reversal and continuation
of the technical trend. With so many sources of trend signals
(price patterns, volume, gaps, moving averages, momentum
oscillators, volatility, and fundamentals), how can the current
technical trend be anticipated effectively? The answer is to rely
on a collection of several signals of different types and to avoid
confirmation bias by objectively studying the signals and
drawing conclusions about what they reveal.

Endnotes
1 Au, Thomas. A Modern Approach to Graham and Dodd Investing. Hoboken, NJ: John
Wiley & Sons, 2004, p. 28.
2 Black, Fischer. “The Dividend Puzzle.” Journal of Portfolio Management (1976)2, pp.
5–8.
3 www.mergent.com
4 Gill, Amarjit, Nahum Biger, and Rajendra Tibrewala. “Determinants of Dividend
Payout Ratios: Evidence from United States.” The Open Business Journal (2010) 3, pp.
8–14.
5 Higgins, R.C. “Sustainable Growth under Inflation.” Finance Manage (1981)10, pp.
36–40.
6 Chisholm, A. M. An Introduction to International Capital Markets. West Sussex, UK:
John Wiley & Sons, 2009. p. 428.
7 Gibson, Charles H. Financial Reporting and Analysis: Using Financial Accounting
Information. Mason, OH: South-Western Cengage Learning, 2012, pp. 275–76.
Chapter 15
Overview: Putting It All Together
The possible combinations of initial and confirming signals are
vast. This chapter provides examples of several combined
signals designed not only to demonstrate how dissimilar
patterns and indicators work together, but also to show how
trends develop, change, and reverse.
To review a few of the basics of trend analysis:
1. There are three directional types of trends, bullish, bearish,
and consolidation. The consolidation is most often
described as a pause between other trends or as a period of
indecision. These are true observations, but consolidation
may last many months or even years. So as a primary
trend, the consolidation pattern is a valid “directional”
trend with its sideways movements and range-bound
patterns.
2. Changes in trend direction may be anticipated by recognizing
coming breakout signals, which include numerous types of
indicators (candlesticks, price patterns, volume, moving
averages, and momentum oscillators). Because a specific
directional signal invariably indicates a change in the
current trend, many observers believe that the end of
consolidation cannot be identified because there is no trend
to reverse. However, specific changes in the price behavior
within consolidation do provide useable signals; these
include narrowing breadth by way of wedges or triangles
combined with price proximity to resistance or support.
 3. Recognizing how different indicators cross-confirm improves
the accuracy of trend forecasting. Understanding what
something means in the moment is the key, and recognizing
how different kinds of patterns (both reversal and
continuation) behave together, is a more accurate method
for spotting changes than reliance on single types of
indicators.
4. Trends and trend patterns are all relative. When you review
a two-year chart, certain patterns emerge that are not as
visible as on a three-month chart. However, a small pattern
on a longer-term chart has the same significance as a
shorter pattern on a very limited chart period. For example,
on a two-year chart, a three-month secondary trend
appears only briefly, about the equivalent of a three-week
or four-week secondary trend on a three-month chart. In
studying the nature of trends, keeping this perspective in
mind helps in ensuring that the analysis relates to the
relative contrast between trend patterns and not only to
actual duration. This key attribute of trends—applicability
of patterns over all time periods—is a feature of the charts
and examples that follow.

Key Point: To track trends accurately, you need to know the

types of trends, signals, and relative significance of trend shapes.

In this chapter, five specific types of changes to trends are

examined: moves from directional to consolidation trends,
volatility in secondary trends, large price moves as signals of a
primary trend ending, secondary trends leading to resumption
of primary trends, and failed breakouts during a consolidation
trend.
 These represent only five trend patterns out of many
possible variations. These were selected because they are
patterns experienced repetitively, and because spotting the
different signals adding to a coming change are evident when
checking the many different types of indicators.

Moving from Downtrend to Consolidation

The first of these five formation types is seen when a primary

directional trend (bullish or bearish) ends with a move to
consolidation. This occurs with several specific signals and
involves two important points of recognition: understanding
that the current primary trend is ending and then spotting a
likely revision into a period of consolidation.
This occurs often and is a rational pattern. Once a price
evolves to the point that it exhausts a current trend, a period of
uncertainty is likely to follow. Or, in the alternative, the end of a
long-term trend can also lead to a period of agreement, not
uncertainty. When buyers and sellers agree that a newly
established range is reasonable for a stock, consolidation is the
acknowledgment that the newly set range works, at least until a
change in the supply and demand perception leads price into a
new bullish or bearish phase. In this period, one attribute
confirming consolidation is a narrowing of the breadth of
trading.

Key Point: A trend reversal does not always lead to movement in

the opposite direction. It may also lead to a new consolidation
trend.
An example of a downtrend resolving with a move into
consolidation is seen in Figure 15.1. In this case, a volatile price
pattern (as much as 11 points from top to bottom) was replaced
with a 4-point range.

Figure 15.1: Downtrend moving to consolidation

Source: Chart courtesy of StockCharts.com

The downtrend took prices down 11 points in only two months.

After a bounce to higher levels unable to move above $43 per
share, price settled into a range between the previously set
support of $36 and newly-set resistance of $40 per share.
The consolidation trend, confirmed by the narrowing range,
and as a result reduced volatility, demonstrated how
consolidation replaces a fast-moving directional trend. The next
move may be either bullish or bearish; to anticipate either,
specific signals must appear. In consolidation, that usually
means a further narrowing of breadth. Over the three months
beyond the period shown, resistance held and support declined
further down to approximately $33 per share. However, there
were no strong signals indicating a bullish or bearish move
away from consolidation.
 In consolidation, traders may be frustrated with the lack of
strong directional movement; however, this pattern is a natural
occurrence between other primary trends. No directional trend
will last forever, and alternating bullish and bearish trends are
difficult to track. The duration of any trend is impossible to
know in advance, and past duration patterns are not reliable
indicators. The advantage to consolidation is that it reassures
traders that the supply and demand forces are working. It is not
natural for the two sides to trade places repeatedly; it makes
more sense to experience periods in which buyers or sellers are
in control, alternating with periods of general agreement
between the two sides (consolidation). This is confusing in the
sense that the next step in evolution of price can not be known
until a breakout occurs; however, this does not mean that
consolidation is a lack of trend. It is a period of agreement, and
the confusion is not about the range bound price level but
about how long it will last and, more to the point, which
direction price will move next.
In the example above, the period between April 2013 and
July 2014, accounted for most of the price movement, including
conclusion of the downtrend and establishment of the
consolidation trend. In Figure 15.2, a closer look is taken at this
period, including explanation of how moving average crossover
confirmed these primary trend movements.
 Figure 15.2: Primary trend changes signaled with MA crossover
Source: Chart courtesy of StockCharts.com

The combination of MA analysis and other signals tells the story

of change from downtrend to consolidation. The first signal was
price crossing below both MA lines in June 2013. This bearish
indicator occurred as resistance was set at $43 per share. When
MA lines converged from October through December, the
resistance level was tested. A head and shoulders pattern then
formed, confirming what the price crossover predicted: prices
were likely to continue declining.

Key Point: Trend direction is signaled by many different

indicators, both reversal and continuation.

As the breadth of trading narrowed, resistance declined and

was reset at $40 per share. At the same time, both MA lines
closed ranks with price, confirming that the previous volatility
was settling down. This trend, another signal of possible
consolidation, was accompanied by the end of the bearish trend
as support settled in around $36 and did not move lower until
the end of the period charted in the previous chart.
Secondary Trend Volatility

The move from one primary trend to another is likely to be

signaled and confirmed by a variety of signals. By the same
argument, secondary trends often provide short-term volatility
within a long-term consolidation trend.

Key Point: When primary trends are interrupted by secondary

trends, high volatility in that period is not uncommon.

For example, in Figure 15.3 a long-term consolidation, with the

price range-bound with a five-point breadth between $21 and
$16 i, was tested with short-term volatility moving price as high
as $25 and as low as $14, with several failed breakouts both
above and below. This pattern was shown over two years on the
chart in Figure 15.3.

Figure 15.3: Secondary trend volatility during primary consolidation

Source: Chart courtesy of StockCharts.com

The narrow 5-point consolidation trend extended throughout

the two years, even with repeated breakouts on both sides. All
these failed, however, strengthening the consolidation trend for
the long term. Taking a closer look at the three-month period
between May and July 2013, the attributes of the failed
breakout above resistance demonstrated how momentum and
candlesticks combine to show how long consolidation held. This
is found in Figure 15.4.

Figure 15.4: Bearish trend signaled by RSI

Source: Chart courtesy of StockCharts.com

A pattern developed forecasting the failure of this breakout. As

prices trended higher and eventually moved above resistance,
RSI was in the overbought range for three full weeks. This is
unusual; most of the time RSI remains in the middle between 70
and 30 and moves higher or lower only briefly. In this case, the
overbought signal was exceptionally strong.
As prices began retreating, the reaction swing was signaled
by the pattern of identical three crows. This is like the three
black crows but is a stronger bearish signal. Each session opens
at the same price as the previous close, meaning there are no
price gaps. A rare signal, identical three crows forecasts further
price decline; and as the chart reveals, the initial overbought
signal by RSI, followed by identical three crows, moved price
away from the high and back into the range bound
consolidation pattern. The consolidation was further confirmed
by RSI remaining in the mid-range between 70 and 30 for the
remainder of the period.

Large Price Move Ending Primary Trend

Primary trends conclude in many ways. Some just fizzle out,

others reverse suddenly, and some are clearly marked by a
large price move. Figure 15.5 has an example of a chart with
clear signals of the end of a primary trend, consisting of a 3-
point drop after a consistent run-up in price, and then a fix-
point drop confirming that the bullish trend was over.

Figure 15.5: Large price decline ending primary trend

Source: Chart courtesy of StockCharts.com

The possibility that the drop in late July 2014 was only a
secondary trend or an extended retracement was present when
it first occurred. However, once the second, large price drop
occurred, it was clear that a new trend was underway. In fact,
price levels fell as low as the range between $7 and $8 per share
that were previously seen two years earlier.

Key Point: Big changes in price levels, especially with gaps and
volume spikes, are often found at the end of a primary trend.

Taking a closer look at the last three months of this chart,

numerous signals confirmed the conclusion of the primary
trend and replacement by a very low-breadth consolidation
period. This is shown in Figure 15.6.

Figure 15.6: Sudden breadth shift confirmed by MACD and volume

Source: Chart courtesy of StockCharts.com

The initial contrast from beginning to end of this period was

seen in the low volume during October, offset by the volume
spikes in November and then a quick return to low volume.
This pattern was mirrored in price breadth: it was under 1
point throughout October and returned to this small breadth
once the large price drop has taken place. When large price
moves—especially with big gaps and volume spikes—occur, it
often is accompanied by highly volatile breadth of trading and
volume, forecasting even more volatility to follow. In this case,
however, the comparison of price breadth and volume,
interrupted by the volume spikes and price gap, set up the
consolidation and confirmed that the primary bullish trend was
done.
The change from uptrend to consolidation was further
confirmed by the change in momentum, as measured by MACD.
The signal line showed little activity, but the large price gap and
volume spike were anticipated by the bearish crossover that
began immediately before these clear signals. However, after
the crossover, both MACD MA lines remained below the signal
line, and that line returned to its very narrow range, also
mirroring the volume and price levels.

Primary Trend with Secondary Trend

Contrasting the change from primary trend to consolidation,

the opposite pattern presents a problem in interpretation.
When a primary trend suddenly undergoes a huge price gap in
a direction opposite the trend, does it mean the trend is over? In
the previous example, volume and momentum confirmed the
likelihood that the primary trend was done.
However, a similar pattern can also be found when a
primary trend is only interrupted by a secondary trend with a
likely return to the primary trend. For this, a set of clear signals
must forecast this price pattern rather than signaling the end of
the primary trend. The chart in Figure 15.7 provides an
example of the interruption of a primary trend by a secondary
trend lasting less than two months.

Figure 15.7: Primary trend with secondary trend

Source: Chart courtesy of StockCharts.com

How do you know this is a secondary trend rather than a new

consolidation or downtrend? Looking at the entire two years,
the pattern is easy to read in hindsight. However, at the point
immediately after the 12-point drop in price, how could this be
interpreted?

Key Point: Changes in primary trends may lead to reversal or

consolidation. Knowing which is likely requires thorough chart
analysis.

The answer is found in the next chart (see Figure 15.8), which
focused on four months from November 2013 through February
2014. This chart provides the clues forecasting a return to the
primary trend rather than establishment of a new trend.
 Figure 15.8: Signals of secondary trend start and finish
Source: Chart courtesy of StockCharts.com

The initial price gap accompanied by volume spikes looked very

much like the end of a trend. In addition, preceding narrow
trading breadth was followed by a similar narrowing in
February. The on balance volume (OBV) also tracked the price
decline with a drop in index level, which then tracked low
volume and low-breadth price. However, when RSI was also
reviewed, the forecast strongly indicated a return to higher
price levels.
RSI moved into oversold at the point of the big gap at mid-
January. It remained in oversold territory for one month and
did not return to mid-range until early February. It is unusual
for RSI to remain outside of the 30–70 range for more than a
few days. This revealed a low likelihood of either a new
downtrend or consolidation. Looking back at the previous two-
year chart, the new primary trend did resume, but not until late
May. In the period of two months right after the large price gap,
the eventual return to the primary bullish trend was not clear
in looking at price and volume alone. However, the oversold
condition of RSI revealed that price was likely to recover and
begin moving upward once again.

Consolidation Primary Trend with Failed Breakouts

The price patterns and secondary trends within a long-term

primary consolidation trend can be confusing. The temptation
is to assign great value to strong but short-term price
movements when, in review of a longer time span, some types
of movements take on a character other than specific trends.
These interim movements in price may represent failed
breakouts from the range-bound trend and not new trends in
their own right.
For example, Figure 15.9 contains a series of strong price
movements ranging from $10 down to $5 over a period of two
years. The appearance of this chart is one of high volatility;
however, when analyzed for the repetitive nature of price
movement, a different picture emerges.
 Figure 15.9: Series of failed breakouts from consolidation
Source: Chart courtesy of StockCharts.com

In fact, as indicated on the chart, this two-year price history

was a primary consolidation trend with a narrow range from
just below $7 to just below $8.50. This 1.5-point range was
extremely limited. The frequent moves above and below that
range shared certain characteristics. First, they lasted between
one and three months. These may be called secondary trends
given their duration or they may be classified as failed
breakouts. A second feature seen in each case was the gapping
price action setting up the breakout and then marking a return
into range. This means that all four instances (one above
resistance and three below support) formed as island clusters
(see Chapter 10). Third, the extent of these breakouts was never
greater than 1.5 points away from the consolidation range.
Fourth, and most notably, was the consistent and repetitive
nature of these breakouts.

Key Point: A signal that a primary consolidation trend will

continue may consist of a series of breakout attempts and failed
breakouts.
Each island cluster was characterized further by clear reversal
signals and confirming secondary signals. These are not evident
on the two-year chart with compressed trading and set up as a
line chart. However, an analysis of a portion of this chart—
between January and June 2014—is revealing in the
identification of a reversal, confirmation, and continuation
signals. These are shown in Figure 15.10.

Figure 15.10: Failed breakouts returning to consolidation

Source: Chart courtesy of StockCharts.com

The breakout period from the beginning of the charted period

through mid-April began with a bearish reversal signal the
identical three crows. This was a stronger bearish signal than
the more common three black crows and was quite rare. Its
feature included three consecutive declining sessions with each
opening price identical to the preceding closing price. The same
pattern was highlighted earlier in Figure 15.4 (bearish trend
signaled by RSI).
 This downward move was strong, notably as it occurred at
the point of breakout below support. If confirmed, it could
mark the beginning of a new bearish trend away from the
primary consolidation trend. However, price settled at the $5.25
price level. A bullish doji star forecast a bullish reversal three
weeks before price began trending upward once more.
The point of reversal contained strongly gapping price
action accompanied by a large volume spike. The return into
range was further confirmed with a continuation signal, the
bullish side by side white lines. Price levels quickly returned to
previously established support levels and the consolidation
resumed. Although the island cluster in this case lasted more
than two months, it was part of a repetitive pattern that was
clearly found on the previous longer-term price chart.

Conclusion

The study of trends relies on signals and confirmation. These

may be found in some degree of regularity and with some level
of consistency. It is rare to find a trend lacking in some form of
signal. The occurrence of false signals and failed confirmation
usually contains its own set of attributes:
1. Reversal occurs after a weak or short-term trend. When a
trend is minimal— meaning it has a very slight degree of
change—and when it is short term, lasting a matter of days
rather than weeks or months, a reversal is also minimal. A
true trend should contain specific and easily identified
price movement. This is in one of three directions: upward,
downward, or sideways. The longer the trend, the more
important an initial reversal signal.
2. The reversal signal is weak. After a weak or short-duration
trend, the reversal signal is likely to be weak as well. This
means that rather than strong breadth of trading and
specific offsetting directions between multiple sessions
within the signal, the sessions meet the criteria, but only to
a minimum degree. A weak reversal should be viewed with
caution; it is the attribute of likely failure.
3. Confirmation is also weak. Be aware of confirmation bias. A
weak reversal may be confirmed, but by an equally weak
confirming signal. The analyst’s desire to confirm may lead
to acceptance of weak reversals and confirmation signals,
but in combination they point to a higher likelihood of
failure.
4. The resulting price pattern is either indecisive or it acts
contrary to the signals. The failure of a weak reversal and
confirmation leads to failure of the price pattern itself. The
price will display indecision or will completely ignore those
weak signals. In hindsight, the weaknesses are easily
spotted, but in the moment, impatience or assumption may
easily mislead an investor into seeing the end of a trend
when the momentary price movement lacks significance,
represents a secondary or swing trend, or is only a
retracement of a few sessions.
5. Proximity is not ideal. The most likely placement of a
reversal signal is at proximity to resistance or support, or
moving through those levels. If the move also involves
strong price gaps and volume spikes, reversal is close to
certain. When reversal signals appear at mid-range, the
reversal is less likely and the price movement may
represent normal trading within the established range. This
is frustrating for investors wanting to see a reversal from a
bullish or bearish trend, or a breakout from consolidation.
 However, every trend varies in duration and it makes sense
to act only when the signals are strong.

Trend analysis involves numerous signals and patterns.

Analysis is improved when you can adopt an objective view
and when the trend itself is acknowledged as likely to continue
until a change is identified. This is one of the principles in the
Dow theory: trends continue until specific signals show that they
have ended (Chapter 1). Even so, in the haze of current price
movement, this rule is easily overlooked. A starting point for all
trend analysis is to recognize the uncertain nature of trends
and to adopt the view that within a trend, price movement is
likely to be erratic with offsetting secondary and swing trends
and that what appears as a reversal or breakout could be
misleading and uncertain.

Key Point: Trends do not end without reason. They continue

until signals appear revealing a likely conclusion; these are
predictable and recognizable in trend patterns and changes.

Even with this uncertainty, however, investors can devise a set

of policies to use signals and confirmation to recognize the
attributes of a trend as it slows down or reverses. The rich body
of potential signals in the form of price patterns, candlesticks,
moving averages, momentum, volume, and volatility add up to
an arsenal of analytical tools that define the skills of the chartist
and that inevitably improve the timing of buy-and-hold
decisions as well as the faster-moving swing trade. It all relies
of how effectively you apply the skills of many signals making
up the science of trend analysis.
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Index
A
Abandoned baby signal 1, 2, 3
Accumulation/distribution 1
A/D index 2 1
A/D line 1, 2
Adjusted A/D 1
Agreement 1, 2, 3, 4, 5
Analysts 1, 2, 3, 4, 5, 6, 7, 8, 9
Ascending channels 1
Assumptions 1, 2, 3, 4, 5, 6, 7, 8, 9
– – random 1, 2
ATR (average true range) 1
Attributes 1, 2, 3, 4, 5, 6, 7, 8, 9
Average reversal indicators 1
Average true range. See ATR
Averages
– moving 1, 2, 3, 4, 5, 6, 7, 8, 9
– second 10, 1, 2

B
Baby, abandoned 1, 2, 3, 4, 5, 6
Band width 196, 1
Bands 1, 2, 3, 4, 5, 6
– lower 1, 2, 3, 4, 5, 6
Bargain-priced stock approaches 1
Basis 1, 2, 3, 4, 5, 6, 7
BB. See Bollinger Bands
Bearish 1, 2, 3, 4, 5, 6, 7, 8, 9
Bearish breakout 1
Bearish confirmation 1
Bearish crossover 1, 2, 3
Bearish direction 1, 2
Bearish divergence 1, 214–15, 2
Bearish harami 1, 2, 3, 4, 5
Bearish harami cross 1, 2
Bearish meeting lines 1
Bearish movements 1, 2
Bearish piercing lines 1
Bearish price movement 1
Bearish reversal 1, 2, 3, 4, 5, 6, 7, 8, 9
– legitimate 1
– rising wedge signals 1
– signaled 1
– strong 1
Bearish reversal signal 1, 2
Bearish side-by-side lines 1, 2
Bearish signal 1, 2, 3, 4, 5, 6, 7, 8, 9
– black 1
– confirming 1
– initial 1
– strong 1
– stronger 1, 2
Bearish thrusting lines 1
Bearish trend 1, 2, 3, 4, 5, 6, 7, 8, 318
– new 1, 2
– new primary 1
– new secondary 1
– possible 1
– primary 66, 1, 2, 3
– secondary 1, 2
Bearish version 1, 2, 3, 4, 5, 6
Beta, stock’s 1, 2
Big Lots 1, 2, 3
Black crows 1, 2, 3, 4, 5, 6, 7, 8
Black session 1, 2, 3, 4, 5, 6, 7
– consecutive 1
Blind spots 1, 2, 3, 4
Bollinger Bands (BB) 1, 2, 3, 4, 5, 6, 196–99, 7, 8
Bollinger Bands aid in interpreting price trends 1
Bollinger Squeeze 1, 196–99
Bottom 1, 2, 3, 4, 5, 6, 7, 8, 9
– rectangle 1, 2
Bottom formations, double 1
Bouncing price 1
Breadth 1, 2, 3, 4, 5, 6, 7, 8, 9
– 10-point 1
– current 1, 2, 3, 4, 5
– fifty-two-week 1
Breadth of trading 1, 2, 3, 4, 5, 6, 7, 8, 9
Breadth test 1
Breakaway 1, 2, 3
Breakaway gaps 1, 2, 3
Breakout 1, 2, 3, 4, 5, 6, 7, 8, 9
– following 1, 2
– forecasting 1
– potential 1, 2
– short-term 1
– strong 1, 2
– true 1, 2, 3
Breakout gaps 1
Breakout period 1, 2
Breakout price movement 1
Breakout reversal and continuation 1
Breakout signals 1, 2
– recognizing coming 1
– strong 196
Breakouts and reversals 1
Bubble effect 1
Bull markets 1, 2, 10, 3, 4, 5
Bull trend 1, 2, 3, 4
– long-term primary 1, 2, 3, 4
Bullish 1, 2, 3, 4, 5, 6, 7, 8, 9
– side-by-side 1
Bullish breakout 1, 2, 3
– strong 1
Bullish confirmation 1, 2
Bullish continuation 1, 2, 3, 4
Bullish continuation signal 1, 2
– strong 1
Bullish crossover 1, 2
Bullish divergence 1, 214–15, 2
Bullish doji star 1, 2
Bullish engulfing 1, 2, 3, 4, 5
Bullish engulfing signals 1
Bullish gap 1, 2
Bullish harami 1, 2, 3, 4, 5
Bullish indicator 1, 2
Bullish morning star reversal signal 1
Bullish piercing lines 1, 2
Bullish price movement 1, 2
Bullish reversal 1, 2, 3, 4, 5, 6, 7, 8, 9
– expected 1
– signaling 1
– strong 1, 2, 3
Bullish reversal candlestick 1
Bullish reversal signal 1, 2
– strong 1
Bullish reversals start 1
Bullish side-by-side 1, 2, 3
Bullish side-by-side continuation signal 1
Bullish side-by-side lines 1, 2
Bullish sign 1
Bullish signal 1, 2, 3, 4, 5, 6, 7, 8
– strong 1, 2
– weak 1
– white side-by-side lines 1
Bullish signal results 1
Bullish tasuki gap continuation signal 1
Bullish tasuki gap signal 1
Bullish thrusting lines 1, 2, 3, 4, 5
Bullish thrusting lines continuation signal 1
Bullish trend 1, 2, 3, 4, 5, 6, 7, 8, 9
– established 1
– established primary 1
– initial 1
– long-term 1, 2, 3, 4
– long-term primary 1, 2, 3, 4
– major 10
– new 1, 2
– new primary 1
– secondary 1
– strong 1, 2, 3, 4
Bullish trend direction 1
Bullish trend gaps 1
Bullish version 1, 2, 3, 4, 5
Buyers 1, 2, 3, 4, 5, 6, 7, 8, 9
Buyers and sellers 1, 2, 3, 4, 5, 6, 7, 8, 9

C
Calculations 1, 2, 3, 4, 5, 6, 7, 8
Candlestick analysis 1, 2, 3, 4, 5
Candlestick reversal signal 1
Candlestick signals 1, 2, 3, 4, 5, 6, 7, 8
– strong 1, 2
– three-session 1
Candlesticks 1, 2, 3, 4, 5, 6, 7, 8, 9
– black 1, 2, 3, 4, 5
– long 1, 2, 3, 4, 5
Canon 1, 2
Capitalization, total 1, 2, 3, 4
Capitalization ratio, debt to total 1, 2, 3, 4, 5, 6
CBOE (Chicago Boards Option Exchange) 1
CFRA stock reports 1, 2, 3, 4
Chaikin money flow 1
Chaikin oscillator 1
Channel 1, 2, 3, 4
– falling 1
– lower 1
Channel line types 1, 2
Channel lines 1, 2, 3, 4, 5, 6, 7, 8, 9
Chart 1, 2, 3, 4, 5, 6, 7, 8, 9
– longer-term 1, 2, 3
– previous 1, 2, 3, 4, 5
Chart analysis 1, 2, 3, 4
Chart courtesy 1, 2, 3, 4, 5, 6, 7, 8, 9
Chart gaps 1
Charted period 1, 2, 3, 4, 5, 6, 7, 8, 9
Chartists 1, 2, 3, 4, 5, 6, 7, 318
Chicago Boards Option Exchange (CBOE) 1
Clear reversal signals 1, 2, 3
Close proximity 1, 2, 3, 4, 5, 6, 7, 8
Closing prices 1, 2, 3, 4, 5, 6, 7, 8, 9
– days of 1
CMF (Chaikin money flow) 1
Coincidental price patterns 1, 2
Coming price trends 1
Coming trend reversal 1
Commitment 1
Common gaps 1, 2, 3, 4
Companies 1, 2, 3, 4, 5, 6, 7, 8, 9
– low-volatility 1
– traded 1
Comparing Fundamental Trends 1, 2, 3, 4, 5
Confidence 1, 2, 3, 4, 5, 6, 7, 8, 9
Confidence level 1, 2, 3
Confirmation 1, 2, 3, 4, 5, 6, 7, 8, 9
– clear 1, 2
– independent 1, 2
– initial 1, 2
– multiple 1, 2
– strong 1, 2, 3, 4, 5, 6, 7, 8, 9
– weak 1, 2, 3
Confirmation bias 1, 2, 3, 4, 5, 6
Confirmation signals 1, 2, 3, 4, 5, 6, 7, 8, 9
– distinct 1
– – lagging 1
– secondary 1
– strong 1
– useful 1
Confirmation trends 1
Confirming signals 1, 2, 3, 4, 5, 6, 7, 8, 9
Connecting 1, 2, 3, 4, 5, 6, 298, 7, 8
Consolidation 1, 2, 3, 4, 5, 6, 7, 8, 9
– downtrend to 1
– higher price 1
– long 1, 2, 3
– long period of 1, 2
– long-term 1, 2, 3
– period of 1, 2, 3, 4, 5, 6, 7, 8, 9
Consolidation breakout 1
Consolidation pattern 1, 2, 3, 4, 5, 6, 7, 196, 8
– extended 1, 2
Consolidation plateaus 1, 2
Consolidation primary trend 1
Consolidation range 1, 2, 3, 4, 5
Consolidation reading 1
Consolidation resistance, prior 1
Consolidation trend 1, 2, 3, 4, 5, 6, 7, 8, 9
Continuation 66–68, 1, 2, 3, 4, 5, 6, 7, 8
– long-legged doji signals 1
– marked 1
– strong 1, 2
– trend’s 1
– white bullish side-by-side lines forecast 1
Continuation and consolidation 1, 2, 3
Continuation candlestick signal 1
Continuation confirmation 1
Continuation patterns 1, 2, 3, 4, 5, 6, 7, 8, 9
Continuation signal
– filled 1
– reliable 1
Continuation signal types 1
Continuation signaling 1, 2
Continuation signals 1, 2, 3, 4, 5, 6, 7, 8, 9
Continuation signals forecast 1
Contrarians 2–4, 1, 2, 3, 4
Convergence 1, 2
Corrections 2, 1, 2, 3, 4, 5
Cost 1, 2, 3, 4
Crosses 1, 2, 3, 4, 5, 6
Crossover 1, 2, 3, 4, 5, 6, 7
Crows 1, 2, 3, 4
Current ratio 1
Cyclical secondary trends 1

D
Data set 1, 38, 2
Days 1, 2, 3, 4, 5, 6, 7, 8, 9
– long 1, 2, 3
– previous 1, 2, 3, 4, 5, 6, 7
– second 1, 2, 3
Debt 1, 2, 3, 4, 5, 6, 7
Debt service 1, 2
Decision tree 1
Declining 1, 2, 3, 4, 5, 6, 7, 8, 9
Declining resistance 1, 2, 3, 4
– marked 1
Declining stocks 1
Demand 1, 2, 3, 4, 5, 6, 7, 8, 9
Descending triangle 66–67, 1, 2, 3, 4
Deviations 1, 2
Diamond 1, 2
Dilemma, prisoner’s 1, 2
Direction 1, 2, 3, 4, 5, 6, 7, 8, 9
– new 1, 2, 3, 4, 5
– opposite 1, 2, 3, 4, 5, 6, 7, 8, 9
– reversed 1
– trend’s 1, 2
Direction price 1, 2, 3, 4
Directional signals 1, 2, 3
– clear 1
Directional trend 1, 2
– fast-moving 1
– primary 1
Divergence 1, 2, 3, 4, 5, 6, 7, 8, 9
– moving average convergence 1, 2
Divergence Analysis 1
Divergence signals 1, 2, 3
Diversification 1, 2, 3
Dividend analysis 1
Dividend fundamentals 1
Dividend trends 1, 2
– positive 1, 2
Dividends 1, 2, 3, 4, 5, 6, 7, 8, 9
– value of 1
DJIA (Dow Jones Industrial Average) 1, 2, 3, 4, 5, 6, 7, 8
DJIA trend reversal 1
Doji 1, 2, 3, 4, 5, 6, 7
Doji star 1, 2, 3, 4, 5
Dollar values 1, 2, 3
Double bottom 1, 2, 3, 4, 5, 6, 7, 8, 9
Double bottom signals 1, 2
Double continuation signal 1
Double crossover 1
Double tops 1, 2, 3, 4, 5, 6, 7, 8, 9
– third 1
Double tops and bottoms 1, 2, 3, 4, 5, 6
Dow 1, 2, 3, 4, 5, 6, 7, 8, 9
Dow theory 1, 2, 3, 318
Dow theory applied 1, 2
Downside breakout 1, 2
Downside gap 1, 2, 3, 4, 5, 6, 7, 8
Downtrend 1, 2, 3, 4, 5, 6, 7, 8, 9
– coming 1
– current 66
– forecast 1
– initial 1
– lacking 1
– new 1, 2, 3, 4
– prior 1
– secondary 1
– sharp 1
– short-lived 1
– short-term 1
– strong 1, 2, 3, 4, 5
Downtrend climax 1
Downtrend line 1
Downtrend movement 1
Downward gap 1, 2, 3, 4, 5, 6, 7, 8, 9
Duration 1, 2, 3, 4, 5, 6, 7, 8, 9
– long 1, 2
Dynamic trend 1, 2, 3, 4, 5, 6, 7, 8
– previous 1, 2

E
Earnings 2–4, 1, 2, 3, 4, 5, 6, 7, 8
Earnings surprises 2, 1, 2, 3, 4, 5, 6
– reaction to 1, 2
Earnings trends 1, 2, 3, 4
Eastern continuation signals 1, 2, 3, 4, 5, 6
Eastern patterns 1, 2, 3, 4, 5, 6, 7, 8, 9
Efficient market hypothesis. See EMH
EMA (exponential moving average) 1, 2, 3, 4
EMA lines 1
EMA signals 1
EMH (efficient market hypothesis) 1, 2, 3, 10, 4, 5, 6, 7
EMH, primary trend confirmation challenges 1
Emotions 1, 2, 3
Engulfing pattern 1, 2, 3
Equities 1, 38–39, 2, 3, 4
Equity positions 1, 2, 3
Evening star 1, 2, 3
Exceptions 1, 2, 3, 4
Ex-dividend date 1
Ex-dividend gaps 1
Exhaustion gaps 1, 2, 3, 4, 5

F
Factors 2, 1, 2, 3, 4, 5, 6, 7, 8
Failed breakouts 1, 2, 3, 4, 5, 6, 7, 8, 9
Falling price trends 1
Falling resistance lines 1
Fat tails 1, 2
Fibonacci retracement 1
Fibonacci sequence 1
Final bearish confirmation 1
Financial information 1
Flags 1, 2, 3, 4, 5, 6, 7, 196
Flags and pennants 1, 2, 3, 4
Forecast 1, 2, 3, 4, 5, 6, 7, 8, 9
Formations, diamond 1, 2, 3
Fundamental analysis 1, 2, 3, 4, 5
Fundamental analysis and confirmation 1
Fundamental trend analysis 1, 2, 3, 4
Fundamental trends 1, 2, 3, 4, 5, 6, 7, 8, 9
Fundamental volatility 1, 2, 3, 4, 5, 6
Fundamentals 1, 2, 3, 4, 5, 6, 7, 8, 9
– strong 1, 2
– weak 1, 2, 3
G
Game theory 1
Gap patterns 1, 2, 3, 4
Gap proximity 1
Gap risk 1
Gapping continuation signal 1
Gapping price pattern 1, 2
Gaps 1, 2, 3, 4, 5, 6, 7, 8, 9
– bearish harami 1
– big 1, 2
– bullish harami 1
– downward moving price 1
– downward-moving 1, 2, 3
– initial 1, 2
– initial price 1
– large 1, 2, 3, 4
– large one-session 1
– large price 1, 2, 3, 4, 5, 6
– repetitive price 1, 2
– strong 1, 2, 3
– strong downward price 1
– strong price 1, 2
– tasuki 1, 2, 3, 4
– unfilled 1
– upward price 1
– volume spikes and price 1, 2
Gaps filled 1, 2
Goldman Sachs 1, 2, 3
Gravestone 1
Growing price trend 1
Growth 1, 2, 3, 4, 5, 6, 7
Growth stocks 2, 1

H
Hammer 1, 2, 3, 4, 5
– inverted 1, 2
Harami 1, 2, 3
Harami cross 1, 2, 3, 4
Head and shoulders 1, 2, 3, 4, 5, 6, 7, 8
Head and shoulders and confirmation 1
Health, trend’s 1
HFTs (high frequency traders) 1
Hidden gaps 1, 2, 3
High frequency traders (HFTs) 1
High prices 1, 2, 3, 4, 5
History 1, 2, 3, 4, 5
Hypothesis, efficient market 1, 2, 3

I
Increased Dividends 1, 2
Index 1, 2, 3, 4, 5, 6, 7, 8, 9
– relative strength 1, 2, 3, 4
Index movement 1, 2, 3
Index value 1, 2, 3, 4, 5, 6, 7
Indicated reversal direction 1
Indicators 1, 2, 3, 4, 5, 6, 7, 8, 9
– candlestick 1, 2, 3, 4
– fundamental 1, 2, 3, 4, 5
– leading 1, 2, 3, 4
– price-based range 1
Individual investors 1, 2
Industrials 1
Initial reversal signals 1, 2, 3
Initial signal 1, 2, 3, 4
Insurance 1, 2
Interest 1, 2, 3, 4, 5, 6, 7, 8, 9
Interpreting price trends 1
Inter-session gaps 1
Inverse head and shoulders 1, 2, 3, 4, 5
Investors 1, 2, 3, 4, 5, 6, 7, 8, 9
Investors and traders 1, 2, 3, 4
Investors tracking prices on charts 1
Island cluster 1, 2, 3

J
JC Penney (JCP) 1
Journal 1, 2, 3, 4, 5, 6, 7

K
Knowledgeable investors 1

L
Lagging indicators 1, 2, 3, 4, 5, 6
Large price move ending primary trend 1
Large volume spikes 1, 2
Lasting bullish trend 1
Lines 1, 2, 3, 4, 5, 6, 7, 8, 9
– horizontal 1, 2
– meeting 1, 2, 3
– piercing 1, 2, 3, 4
– straight 1, 2, 3
– thrusting 1, 2, 3
– white 1, 2, 3, 4
Lines signals 1
Long-legged doji 1, 2, 3, 4, 5
Long-term debt 1, 2, 3, 4, 5
Long-term primary trend 38, 1, 2, 3, 4, 5, 6, 7
Long-term trends 1, 2, 3, 4, 5, 6, 7, 8, 9
Losses 1, 2, 3, 4, 5, 6, 7, 8, 9
Low prices 1, 2, 3, 4, 5, 6, 7, 8, 9
Low prices mark resistance 1
Low volume 1, 2, 3, 4

M
MACD (moving average convergence divergence) 1, 2, 3, 4
MACD lines 1
Magical thinking and trends 1
Managers 1, 2
Market behavior 2–3, 1, 2, 3
Market breakouts 1
Market conditions 1, 2
Market culture 1
Market prices react 1
Market risks 1, 2, 3, 4, 5
Market sentiment 1
Market share 1, 2, 3, 4
Market trends 1
– broader 1
Market value 1
Market volatility 1
Markets 1, 2, 3, 4, 5, 6, 7, 8, 9
– broader 1, 2
– efficient 1
– sub-prime 1
Marking risk 1, 2, 3, 4, 5, 6
MCD 1
Measurement 1, 2, 3
Meeting lines signal 1
MFI (money flow index) 1
MFM (money flow multiplier) 1
MFR (money flow ratio) 1
Middle band 1, 2, 3, 4
Mid-range 1, 2, 3, 4, 5, 6, 7, 8
Misplaced reversal signal 1
Momentum 1, 2, 3, 4, 5, 6, 7, 8, 9
– price-related 1
Momentum and timing of preceding Trends 1
Momentum changes 1, 2
Momentum indicators 1, 2
Momentum of reversal 1
Momentum oscillators 1, 2, 3, 4, 5, 6, 7, 8, 9
Momentum shift 1
Momentum signals 1, 2, 3
– critical 1
Momentum trading 1
Momentum trends 1
Money flow index 1
Money flow ratio (MFR) 1
Month-long downtrend, strong 1
Morning and evening stars 1, 2
Morning star 1, 2, 3, 4
Movement 1, 2, 3, 4, 5, 6, 7, 8, 9
– clear trend 10, 1
Moving average convergence divergence. See MACD
Moving average trading rules in South Asian stock markets 1

N
Narrow range 1, 2, 3, 4, 5, 6, 7, 8, 9
Narrowing breadth 1, 2, 3, 4, 5, 6, 7
Neckline 1, 2, 3, 4
Negative trend 1, 2
Net return 1, 2, 3, 4
News 1, 2, 3, 4, 5, 6, 7, 8
Non-signal 1, 2
Normal distribution 1, 2, 38

O
OBV (On balance volume) 1, 2
Offset 1, 2, 3, 4, 5, 6, 7
Offsetting bullish reversal 1
Oil prices 1, 2
Online charting services 1, 2, 3
Opening 1, 2, 3, 4, 5
Opening price 1, 2, 3, 4, 5, 6, 7, 8
Oscillator 1, 2, 3, 4
Outcomes 1, 2, 3, 4, 5, 6, 7, 8, 9
Overbought 1, 2, 3, 4, 5, 6, 7, 8, 9
Overbought conditions 1, 2, 3, 4, 5, 6
Overbought signals 1, 2, 3
Overconfidence 1
Overreaction 2–3, 1, 2, 3, 4, 5, 6, 7
Oversold 1, 2, 3, 4, 5, 6, 7, 8
Oversold conditions 1, 2, 3, 4, 5, 6, 7
Oversold range 1, 2, 3

P, Q
Past price behavior 1
Past price performance 1, 2
Payout ratio 1, 2, 3, 4, 5, 6
P/E ratio 1, 2, 3, 4, 5, 6, 7, 8
Peaks 1, 2, 3
Pennants 1, 2, 3, 4, 5, 6, 196
Piercing lines reversal signal 1
Piercing lines signal 1
Plateau 1, 2, 3, 4, 5
Portfolio 1, 2, 38, 3, 4, 5, 6, 7
Portfolio managers 1, 2, 3, 4, 5, 6, 7
Portfolios, permanent 1, 2, 3, 4, 5
Positions 1, 2, 3, 4, 5, 6, 7, 8, 9
Possible outcomes 1, 2, 3, 4, 5
Potential reversal signals 1
Power spike 1
Preceding trends 1
Price
– average 1, 2
– combined 1, 2
– current 1, 2, 3, 4, 5, 6, 7, 8, 9
– current stock 1, 2
– final 1, 2
– growing stock 1
– higher 1, 2
– individual stock 1
– large 1, 2, 3, 4
– lower 1, 2
– momentary 1
– moved 1, 2, 3, 4, 5, 6, 7, 8
– moving 1, 2, 3, 4, 5, 6, 7, 8
– opening and closing 1, 2, 3
– right 1, 2
– rising 1, 2, 3, 4
– settlement 1
– spiking 1
– – stock’s 1, 2, 3, 4, 5, 6
– tracking stock 1, 2
Price action 1, 2, 3, 4, 5, 6, 7, 8
– gapping 1, 2, 3
Price activity 1, 2, 3
Price and volume 1, 2, 3, 4, 5, 214, 6, 7, 8
Price averages 1, 2
Price behavior 1, 2, 3, 4, 38–39, 5, 6, 7, 8
– single stock’s 1
Price bottoms 1, 2
Price breadth 1, 2, 3, 4
Price breakout 1, 2
– strong 1
Price breaks 1, 2, 3, 4, 5, 6, 7, 8
Price changes 1, 2, 3, 4, 214, 5, 6
– previous 1
Price charts 1, 2, 3, 4, 5, 6, 7, 8, 9
– previous longer-term 1
Price confirmation 1
Price continuation 1
– dynamic 1
Price correlation 1
Price crosses 1, 2
– current stock 1
Price crossover 1, 2, 3
Price declining 1, 2, 3
Price direction 1, 2, 3, 4, 5, 6, 7, 8, 9
– offsetting 1
– previous 1
Price formation signals 1
Price gaps 1, 2, 3, 4, 5, 6, 7, 8, 9
Price history 1, 2
Price increments 1, 2
Price indicators 1, 2, 3
Price jumps signal change 1, 2, 3, 4, 5, 6, 7, 8, 9
Price levels 1, 2, 3, 4, 5, 6, 7, 8, 9
Price movement 1, 2, 3, 4, 5, 6, 7, 8, 9
– cause 1
– consistent downward 1
– current 318
– downward 1, 2
– dynamic 1
– gapping 1, 2
– inconsistent 1
– influence 1
– longer-term 1
– managing 1
– momentary 1
– opposite 1, 2
– overlapping 1
– past 1
– range-bound 1
– rational 1
– short-term 1, 2, 3, 4, 5, 6
– steady 1
– technical 1
– unpredictable 1
– upward 1
Price pattern indicator 1
Price pattern signals 1, 2
Price patterns 1, 2, 3, 4, 5, 6, 7, 8, 9
Price peaks 1, 2, 3
Price proximity 1, 2, 3, 4
Price range 1, 2, 3, 4, 5, 6, 7, 8, 9
Price retracement 1
Price retreats 1, 2, 3
Price reversals 1, 2, 3, 4
– probability of 1
– short-term 1
– strong 1
Price reverses 1, 2
Price sets 1, 2
Price signals 1, 2, 3, 214, 4, 5
– strongest 1
Price spikes 1, 2, 3, 4, 5
– 1-point 2
– interim 1
– large 1
Price strength 1, 2, 3
Price swings 1
Price tests resistance 1
Price theories 1, 2
Price tops 1, 2
Price trend analysis 1, 2
Price trends 1, 2, 3, 4, 5, 6, 7, 8, 9
– bullish stock 1
– current 1
– historical 1
– stock’s 1
– strong 1
Price uncertainty 1, 2
Price volatility 1, 2, 3, 4, 5, 6, 7
– lower stock 1
Price/earnings 1, 2
Prices drop 1, 2
– large 1
Prices opening 1
Prices ranging 1, 2, 3
Prices spike 1
– low 1
Primary bullish trend 1, 2, 3, 4, 5, 6, 7, 8, 9
Primary consolidation trend 1, 2, 3, 4, 5, 6, 7, 8, 9
– longer-term 1
– long-term 1, 2
Primary downtrends 1, 2, 3
– new 1
Primary trend movements 1
Primary uptrend 1, 2, 3, 4, 5
– new 1
– previous 1
– slow-moving 1
Profits 1, 2, 3, 4, 5, 6, 7, 8, 9
Proximity 1, 2, 3, 4, 5, 6, 7, 8, 9
Proximity of reversals 1, 2
Proximity of reversals to resistance and support 1
Psychology, behavioral 1

R
Railroads 1, 2
Random variables 38, 1
Ratio 1, 2, 3
– price earnings 1
Raw money flow (RMF) 1
Reaction high and low prices 1
Reaction highs 1, 2, 3
Reaction lows 1, 2
Reaction price movement 1
Rectangle top 1, 2
Rectangle top and bottom 1, 2, 3
Relationship 1, 2, 3, 4, 5, 6, 7, 8
Relative strength index. See RSI
Repetitive bearish reversal signals 196
Resistance 1, 2, 3, 4, 5, 6, 7, 8, 9
– falling 1, 2, 3, 4
– flat 1, 2
– marking 1, 2
– new 1, 2, 3, 4, 5
– previous 1, 2, 66
– prior 1, 2, 3, 4, 5, 6
– test 1, 2, 3
– tested 1, 2
– track 1
Resistance level 1, 2, 3, 4, 5, 6
– new 1, 2, 3
Resistance price 1
Resistance zones 1
Resumption of major trend 10–11
Retrace 1, 2, 3, 4
Retracement 1, 2, 3, 4, 5, 6, 7, 8, 9
Retracement patterns 1
Revenue 1, 2, 3, 4, 5, 6, 7, 8, 9
Revenue and earnings 1, 2, 3, 4, 5, 6, 7, 8
Reversal 1, 2, 3, 4, 5, 6, 7, 8, 9
– beginning of 1, 2
– candlestick 1, 2, 3
– coming 1, 2, 3, 4, 5, 196, 6
– confirmation of 1, 2, 3
– forecast 1, 2, 3, 4, 5, 6, 7, 8
– forecasting 1, 2, 3
– identifying 1, 2
– initial 1, 2
– likelihood of 1, 2, 3, 4
– marks 1, 2
– meeting lines 1
– piercing lines 1
– potential 1, 2, 3, 4
– retracements form 1
– short-term 1, 2, 3, 4
– signaled 1
– spot 1, 214
– stock 1
– strong 1, 2, 3, 4, 5, 6, 7, 8, 9
– strong single-session 1
– weak 1
Reversal and confirmation 1, 2, 3, 4
Reversal candlesticks 1, 2
Reversal forecast 1, 2
Reversal in Eastern patterns 1, 2, 3, 4, 5, 6, 7, 8, 9
Reversal in Western patterns 1, 2, 3, 4, 5, 6
Reversal indicators 1, 2, 3, 4
– favorite 1
– strong 1, 2
Reversal meeting lines 1
Reversal patterns 1, 2, 3, 4, 5, 6, 7, 8, 9
Reversal signal
– exceptional 1
– final 1
Reversal signals 1, 2, 3, 4, 5, 6, 7, 8, 9
– reliable 1
– useful 1
Reversal signals beginning 1
Reversal trends 1
Reverse 38–39, 1, 2, 3, 4, 5, 6, 7, 8
Reverse direction 1, 2
Revert 1, 2
Right proximity 1, 2, 3
Rising volume signals 1
Risk 1, 2, 3, 4, 5, 6, 7, 8, 9
– psychology of 1
Risk management 1, 2, 3
Risk management process 1, 2, 3
Risk transfer 1
RMF (raw money flow) 1
RMH 1, 2, 3, 4, 10, 5, 6, 7, 8
Rounding bottom 1, 2, 3
Rounding top 1, 2
RS 1
RSI (relative strength index) 1, 2, 3, 4, 5, 6, 7
Rules 1, 2, 3, 4, 5, 6, 7, 8, 9
Runaway gaps 1, 2, 3, 4, 5, 6
RWH (random walk hypothesis) 1, 2, 3, 4, 5, 6

S
Sample data 1, 38, 2, 3
Scaling 1, 2, 3, 4
Science of trend analysis 1, 2, 3, 4, 5, 318
Secondary downtrend, strong 1
Secondary trend activity 1
Secondary trend identification 1
Secondary trend movements 1, 2
Secondary trend volatility 1
Secondary trends 1, 2, 3, 4, 5, 6, 7, 8, 9
– analysis of 1, 2
– distinct 1
– fast-moving 1, 2
– forming 1
– short-term 1
Secondary trends offset 1
Sellers 1, 2, 3, 4, 5, 6, 7, 8, 9
Services, free charting 1, 2, 3
Session gaps 1
– white 1
Sessions 1, 2, 3, 4, 5, 214–15, 6, 7, 8
– long 1, 2
– middle 1, 2, 3
– previous 1, 2, 3, 4, 5
– second 1, 2, 3
Sessions opening, white 1
Share price 1, 2, 3, 4
Short-term continuation signals 1
Short-term price patterns 1, 2
Short-term reversal signals 1
Short-term trends 1, 2, 3, 4, 5, 6, 7, 8, 9
Shoulders 1, 2, 3, 4, 5, 6, 7, 8, 9
Shoulders patterns 1, 2, 3, 4, 5, 6
Side-by-side lines, black 1
Signal confirmation 1
Signal line 1, 2
Signal patterns 1, 2
Signal strength 1
Signal values 1, 2
Signaling bearish reversal 1
Signaling trend movement 1
Signals 1, 2, 3, 4, 5, 6, 7, 8, 9
– clear 1, 2, 3, 4, 5, 6
– combined 1, 2
– double 1, 2
– early 1, 2, 3
– false 1, 2
– important 1, 2, 3
– independent 1, 2
– multiple 1, 2, 3
– occurring 1, 2
– positive 1
– reliable 1, 2, 3, 4
– repetitive 1, 2
– short-term 1, 2, 3
– strong 1, 2, 3, 4, 5, 6, 7, 8, 9
– stronger 1, 2
– strongest 1, 2, 3
– technical 1, 2, 3, 4, 5, 6
– unconfirmed 1
– valid 1, 2, 3
– weak 1, 2, 3
Signals of supply and demand adjustment 1
Signals reversal 1, 2, 3
Slope 1, 2, 3, 4, 5, 6, 7, 8, 9
SMA (simple moving average) 1, 2, 3
South Asian stock markets 1
Spikes 1, 2, 3, 4, 5, 6, 7, 8, 9
– excessive 1
Spiking price sessions 1
Spinning top 1, 2, 3, 4, 5
Spot 1, 2, 3, 4, 5, 6, 7, 8, 9
Spot market trends 1
Squeeze 1, 2, 196–98
Standard deviations 1, 2, 3, 4, 5, 6, 7
Statistical analysis 1, 2, 3, 4
Statistical tendencies 1, 2, 3, 4, 5
Statistically speaking 1, 2, 3, 4, 5, 6, 38, 7, 8
Statisticians 1, 2, 38–39
Statistics 1, 2, 3, 4, 5
Stochastic oscillator 1, 2
Stock charts 1, 2, 3, 4, 5, 6, 7, 8, 9
– long-term 1
Stock market 1
Stock market investors 1
Stock market prices 1, 2
Stock price behavior 2, 1
Stock price breaks 1
Stock price crosses 1
Stock price levels 1
Stock price trends 1
Stock prices 2–4, 1, 2, 3, 38, 4, 5, 6, 7
Stock prices declining 1, 2
Stock prices of well-managed companies 1
Stock selection 1, 2
Stock trading 1, 2
Stock trends 1, 2, 3, 38, 4, 5, 6, 7
– channeling 1
Stock values 1, 2
Stocks 1, 2, 3, 4, 5, 6, 7, 8, 9
– channeling 1
– company’s 1, 2, 3
– higher-priced 1, 2
– individual 1, 2, 3, 4, 5, 6, 7, 8, 9
– volatile 1, 2
Strategies 1, 2, 3, 4, 5
Strength, trend’s 1
Strong continuation signals 66, 1, 2
Strong price movement reverts 1
Strong price movements ranging 1
Strong reversal signals 1, 2, 3, 4, 5, 6, 7
– lacking 1
Supply 1, 2, 3, 4, 5, 6, 7
Supply and demand 1, 2, 3, 4, 5, 6, 7, 8, 9
– equilibrium of 1
Supply and demand adjustment 1
Support and rzones 1
Support zones 1, 2, 3
Surprises 2, 1, 2, 3, 4, 5, 6
Swing traders 1, 2, 3, 4, 5, 6, 7, 8, 9
Swing trend movement 1
Swing trend reversals 1, 2
Swing trends 1, 2, 3, 4, 5, 6, 7, 8, 9
Symmetrical triangle 1, 2, 3, 4, 5

T
Technical indicators 1, 2, 3, 4
Theory 1, 2, 3, 4, 5, 6, 7
Theory of price movements 1
Theory of trends 2, 1, 2, 3, 10, 4, 5, 6, 7
Thrusting and separating lines 1, 2
Thrusting lines continuation signal 1
Thrusting lines signal 1
Total capitalization ratio 1, 2, 3, 4, 5, 6
Tracking 1, 2, 3, 4, 5, 6, 7, 8, 9
– close 1
Tracking price trends 1, 2, 3, 4, 5, 6, 214, 7, 8
Tracking stock trends 1
Tracking trends 1, 2
Traders 1, 2, 3, 4, 5, 6, 7, 8, 9
Trades 1, 2, 3, 4, 5, 6, 7, 8, 9
– ill-timed 1, 2
Trading gaps 1, 2
Trading rules, technical 1, 2
Transportation Average 1, 2, 3
Trend analysis indicators 1
Trend analysis value 1
Trend analysts 1, 2, 3
Trend behavior 1, 2, 3, 4, 5, 6, 7, 8
Trend climax 1
Trend climax and gap patterns 1, 2
Trend continuation 1
– marking bullish 10–11
Trend direction 1, 2, 3, 4
– primary 1, 2
Trend health 1, 2
Trend indicators 1
Trend momentum 1, 2
Trend movement 1, 2, 3, 4
– historical 1
– marked secondary 1
Trend reversal 1, 2, 3, 4, 5, 6, 7, 8, 9
– confirming 1
– possible 1
– primary 1, 2, 3, 4
– probability of 1
– secondary 1, 2
Trend signals 1
Trend signals work 1
Trend strength 1
Trend volatility 1, 2
Trendline and channel line 1, 2, 3, 4
Trendlines 1, 2, 3, 4, 5, 6, 7, 8, 9
– consistent 1
– established 1, 2
– identifying 1
– internal 1, 2
– middle bearish 1
– perfect 1
– repetitive downward 1
– valid 1
Trendlines and channel lines 1, 2, 3, 4, 5, 6, 7, 8, 9
Trendlines and channel lines track 1
Trends
– bullish swing 1
– coming consolidation 1
– established consolidation 1
– identifying consolidation 1
– long-term consolidation 1
– market’s 1
– marketwide 1
– medium 1
– modified consolidation 1
– multiyear 1, 2
– narrow 1-point consolidation 2
– new consolidation 1, 2, 3, 4, 5
– new consolidation plateau 1
– secondary consolidation 1
– short-duration 1
– single-stock 1
– strong 1, 2, 3, 4, 5, 6
– track 1, 2, 3, 4
– weak 1, 2, 3
– weakening 1, 2
Triangle breakout 1
Triangles 1, 2, 3, 4, 5, 6, 7, 196, 8
– ascending 1, 2, 3, 4, 5, 6, 7, 8
Triangles and wedges 1
Triangle-Shaped Trends 1, 2
Two-session reversal signal 1
Two-session volume spike 1
Two-year chart 1, 2, 3, 4

U
UK stock prices 1
Uncertainty 1, 2, 3, 4, 5, 6, 7, 8, 9
Upper band 1, 2, 196–97, 3, 4
Upside breakout 1, 2, 3, 4
Upside gap 1, 2, 3, 4, 5, 6, 7, 8, 9
Uptrend 1, 2, 3, 4, 5, 6, 7, 8, 9
– coming 1
– gradual 1
– new 1, 2, 3, 4
– secondary 1
– short-term 1
– strong 1, 2, 3, 4
Uptrend line 1
Uptrend signals 1
Uptrend’s success 1

V
Validation 1
Valuation 1, 2, 3
Value 2–3, 1, 2, 3, 4, 5, 6, 7, 8
– fundamental 1, 2, 3
– risk-adjusted 1
– signaling 1
– stock’s 1, 2, 3
Value investments 1, 2
Variables 1, 2, 3, 4, 5, 6, 7, 8
Verizon 1, 2, 3
VIX 1
Volatile 1, 2, 3, 4, 5, 6, 7, 8, 9
Volatile price patterns 1, 2, 3
Volatility 1, 2, 3, 4, 5, 6, 7, 8, 9
– high 1, 2, 3, 4, 5, 6, 7
– technical 1, 2, 3
Volatility index 1
Volatility indicator 1, 2
Volatility levels 1, 2, 3
Volume 1, 2, 3, 4, 5, 6, 214–19, 7, 8
– comparing price to 1, 2
– day’s 1
– decreasing 1
– high 1, 2, 3, 4, 5
– increasing 1
– rising 1
Volume indicators 1, 2, 3, 4, 5, 6, 7, 8, 9
Volume levels 1, 2, 3, 4
– chart’s 1
Volume signals 1, 2, 3, 4, 5, 6, 214, 7, 8
– strong 1
Volume signals aid, calculated 1
Volume spike
– second 1, 2
– strong 1, 2
Volume spikes 1, 2, 3, 4, 5, 6, 7, 8, 9
– distinct 1, 2
Volume spikes and gaps 1
Volume spikes and indicators 1
Volume surge 1, 2
Volume trend 1
– low 1
Volume-marked breakouts 1, 2

W, X, Y
Wait and see forecast 1
Weakness 1, 2, 3, 4, 5, 6, 7, 8, 9
Wedges 1, 2, 3, 4, 5, 6
– falling 1, 2, 3, 4
Wedge-shaped trends 1
Wells Fargo (WFC) 1, 2, 3
Western continuation signals 1, 2, 3, 4, 5, 6
Western patterns 1, 2, 3, 4, 5, 6
Western reversal signals 1
Western signals 1, 2
White candlestick 1, 2, 3, 4
– long 1, 2, 3
White lines continuation signal 1
White session 1, 2, 3, 4
– second 1, 2
White soldiers 1, 2, 3, 4

Z
Zones 1, 2, 3, 4, 5
– resistance and support 1, 2