Introduction to Candlesticks Part 2

Long Shadow Reversals
There are two pair of single candlestick reversal patterns made up of a small real body, one long shadow and one short or non-existent shadow. Generally, the long shadow should be at least twice the length of the real body, which can be either black or white. The location of the long shadow and preceding price action determine the classification.The first pair, hammer and hanging man, are identical with small bodies and long lower shadows. The second pair, shooting star and inverted hammer, are also identical with small bodies and long upper shadows. Only preceding price action and further confirmation determine the bullish or bearish nature of these candlesticks. The hammer and inverted hammer form after a decline and are bullish reversal patterns, while the
shooting star and hanging man form after an advance and are bearish reversal patterns.The hammer and hanging man look exactly alike, but have different implications based on the preceding price action. Both have small real bodies (black or white), long lower
shadows and short or non-existent upper shadows. As with most single and double

candlestick formations, the hammer and hanging man require confirmation before action.

The hammer is a bullish reversal pattern that forms after a decline. In addition to a potential trend reversal, hammers can mark bottoms or support levels. After a decline, hammers signal a bullish revival. The low of the long lower shadow implies that sellers
drove prices lower during the session. However, the strong finish indicates that buyers regained their footing to end the session on a strong note. While this may seem enough to act on, hammers require further bullish confirmation. The low of the hammer shows
that plenty of sellers remain. Further buying pressure, and preferably on expanding volume, is needed before acting. Such confirmation could come from a gap up or long white candlestick. Hammers are similar to selling climaxes and heavy volume can serve to reinforce the validity of the reversal.The hanging man is a bearish reversal pattern that can also mark a top or resistance level. Forming after an advance, a hanging man signals that selling pressure is starting to increase. The low of the long lower shadow confirms that sellers pushed prices lower during the session. Even though the bulls regained their footing and drove prices higher
by the finish, the appearance of selling pressure raises the yellow flag. As with the hammer, a hanging man requires bearish confirmation before action. Such confirmation can come as a gap down or long black candlestick on heavy volume.
Inverted Hammer and Shooting Star

The inverted hammer and shooting star look exactly alike, but have different implications based on previous price action. Both candlesticks have small real bodies (black or white), long upper shadows and small or non-existent lower shadows. These candlesticks mark potential trend reversals, but require confirmation before action.

The shooting star is a bearish reversal pattern that forms after an advance and in the star position, hence its name. A shooting star can mark a potential trend reversal or resistance level. The candlestick forms when prices gap higher on the open, advance
during the session and close well off their highs. The resulting candlestick has a long upper shadow and small black or white body. After a large advance (the upper shadow), the ability of the bears to force prices down raises the yellow flag. To indicate a
substantial reversal, the upper shadow should relatively long and at least 2 times the length of the body. Bearish confirmation is required after the shooting star and can take the form of a gap down or long black candlestick on heavy volume.
The inverted hammer looks exactly like a shooting star, but forms after a decline or downtrend. Inverted hammers represent a potential trend reversal or support levels. After a decline, the long upper shadow indicates buying pressure during the session.
However, the bulls were not able to sustain this buying pressure and prices closed well off of their highs to create the long upper shadow. Because of this failure, bullish confirmation is required before action. An inverted hammer followed by a gap up or long
white candlestick with heavy volume could act as bullish confirmation.
Blending Candlesticks
Candlestick patterns are made up of one or more candlesticks and these can be blended together to form one candlestick. This blended candlestick captures the essence of the pattern and can be formed using the following:
1.The open of first candlestick
2.The close of the last candlestick
3.The high and low of the pattern

By using the open of the first candlestick, close of the second candlestick and high/low of the pattern, a bullish engulfing or piercing pattern blends into a hammer. The long lower shadow of the hammer signals a potential bullish reversal. As with the hammer,
both the bullish engulfing and piercing pattern require bullish confirmation.

Blending the candlesticks of a bearish engulfing or dark cloud pattern creates a shooting star. The long upper shadow of the shooting star indicates a potential bearish reversal. As with the shooting star, bearish engulfing and dark cloud cover patterns require
bearish confirmation.

More than two candlesticks can be blended using the same guidelines: open from the first, close from the last and high/low of the pattern. Blending three white soldiers creates a long white candlestick and blending three black crows creates a long black candlestick.
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Support and Resistance

Support and resistance represent key junctures where the forces of supply and demand meet. In the financial markets, prices are driven by excessive supply (down) and demand (up). Supply is synonymous with bearish, bears and selling. Demand is
synonymous with bullish, bulls and buying. These terms are used interchangeably throughout this and other articles. As demand increases, prices advance and as supply increases, prices decline. When supply and demand are equal, prices move sideways as
bulls and bears slug it out for control.
What is Support?
Support is the price level at which demand is thought to be strong enough to prevent the price from declining further. The logic dictates that as the price declines towards support and gets cheaper, buyers become more inclined to buy and sellers become less
inclined to sell. By the time the price reaches the support level, it is believed that demand will overcome supply and prevent the price from falling below support.

Support does not always hold and a break below support signals that the bears have won out over the bulls. A decline below support indicates a new willingness to sell and/or a lack of incentive to buy. Support breaks and new lows signal that sellers have
reduced their expectations and are willing sell at even lower prices. In addition, buyers could not be coerced into buying until prices declined below support or below the previous low. Once support is broken, another support level will have to be established
at a lower level.
Where is Support Established?
Support levels are usually below the current price, but it is not uncommon for a security to trade at or near support. Technical analysis is not an exact science and it is sometimes difficult to set exact support levels. In addition, price movements can be
volatile and dip below support briefly. Sometimes it does not seem logical to consider a support level broken if the price closes 1/8 below the established support level. For this reason, some traders and investors establish support zones.

What is Resistance?
Resistance is the price level at which selling is thought to be strong enough to prevent the price from rising further. The logic dictates that as the price advances towards resistance, sellers become more inclined to sell and buyers become less inclined to buy.
By the time the price reaches the resistance level, it is believed that supply will overcome demand and prevent the price from rising above resistance.

The chart for HAL shows a large trading range between Dec-99 and Mar-00. Support was established with the October low around 33. In December, the stock returned to support in the mid-thirties and formed a low around 34. Finally, in February the stock
again returned to the support scene and formed a low around 33 1/2.After each bounce off support, the stock traded all the way up to resistance. Resistance was first established by the September support break at 44. After a support level is broken, it can turn into a resistance level. From the October lows, the stock advanced to the new support-turned-resistance level around 44. When the stock failed to advance past 44, the resistance level was confirmed. The stock subsequently traded up to 44 two more times after that and failed to surpass resistance both times.
Support = Resistance
Another principle of technical analysis stipulates that support can turn into resistance and visa versa. Once the price breaks below a support level, the broken support level can turn into resistance. The break of support signals that the forces of supply have
overcome the forces of demand. Therefore, if the price returns to this level, there is likely to be an increase in supply, and hence resistance.The other turn of the coin is resistance turning into support. As the price advances above resistance, it signals changes in supply and demand. The breakout above resistance proves that the forces of demand have overwhelmed the forces of supply. If the price returns to this level, there is likely to be an increase in demand and support
will be found.

In the CPQ example, the stock broke resistance at 25 Nov-99 and traded just above this resistance level for over a month. The ability to remain above resistance established 25 as a new support level. The stock subsequently rose to 34, but then fell back to test support at 25. After the second test of support at 25, this level is well established.

From the PSFT example, we can see that support can turn into resistance and then back into support. PSFT found support at 18 from Oct-98 to Jan-99 (green oval), but broke below support in Mar-99 as the bears overpowered the bulls. When the stock rebounded
(red oval), there was still overhead supply at 18 and resistance was met from Jun-99 to Oct-99.

Where does this overhead supply come from? Demand was obviously increasing around 18 from Oct-98 to Mar-99 (green oval). Therefore, there were a lot of buyers in the stock around 18. When the price declined past 18 and to around 14, many of these
buyers were probably still holding the stock. This left a supply overhang (commonly known as resistance) around 18. When the stock rebounded to 18, many of the green-oval-buyers (who bought around 18) probably took the opportunity to sell. When this
supply was exhausted, the demand was able to overpower supply and advance above resistance at 18.
Trading Range
Trading ranges can play an important role in determining support and resistance as turning points or as continuation patterns. A trading range is a period of time when prices move within a relatively tight range. This signals that the forces of supply and
demand are evenly balanced. When the price breaks out of the trading range, above or below, it signals that a winner has emerged. A break above is a victory for the bulls (demand) and a break below is a victory for the bears (supply).

After an extended advance from 27 to 64, WCOM entered into a trading range between 55 and 63 for about 5 months. There was a false breakout in mid-June when the stock briefly poked its head above 62 (red oval). This did not last long and a gap down a few
days later nullified the breakout (gray arrow). The stock then proceeded to break support at 55 in Aug-99 and trade as low as 50. Here is another example of support turned resistance as the stock bounced off 55 two more times before heading lower. While this does not always happen, a return to the new resistance level offers a second chance for longs to get out and shorts to enter the fray.

In Nov/Dec-99, the LU formed a trading range that resembled a head and shoulders pattern (red arrow). When the stock broke support at 72 1/2, there was little or no time to exit. Even though the there is a long black candlestick indicating an open at 71
13/16, the stock fell so fast that it was impossible to exit above 55. In hindsight, the support line could have been drawn as an upward sloping neckline (blue line) and the support break would have come at 73 1/2. This is only 1 point higher and a trader
would have had to take action immediately to avoid a sharp fall. However, the lows match up rather nicely on the neckline and it is something to consider when drawing support lines.
After LU declined, a trading range was established between 51 and 58 for almost two months (green oval). The resistance level of the trading range was well marked by three reaction peaks at 58. The support level was not as clearly marked, but appeared
to be between 51 and 50. Some buying interest began to become evident around 53, in mid to late February . Notice the array of candlesticks with long lower shadows, or hammers as they are known. The stock then proceeded to form two up gaps on 24-Feb
and 25-Feb, and close above resistance at 58. This was a clear indication of demand winning out over supply. There were still two more opportunities (days) to get in on the action. On the third day after the breakout, the stock gapped up and moved above 70.
Support and Resistance Zones
Because technical analysis is not an exact science, it is sometimes useful to create support and resistance zones. This is contrary to the strategy mapped out for LU, but it is sometimes the case. Each security has its own characteristics and the analysis should
reflect the intricacies of the security. Sometimes exact support and resistance levels are best and sometimes zones work better. Generally, the tighter the range, the more exact the level. If the trading range spans less than 2 months and the price range is relatively tight, then more exact support and resistance levels are probably best suited. If a trading range spans many months and the price range is relatively large, then it is probably best to use support and resistance zones. These are only meant as general
guidelines and each trading range should be judged on its own merits.

Returning to the analysis of HAL, we can see that the November high of the trading range (33 to 44) extended more than 20% past the low, making the range quite large relative to the price. Because the September support break forms our first resistance
level, we are ready to set up a resistance zone after the November high is formed, probably around early December. At this point though, we are still unsure if a large trading range will develop. The subsequent low in December, which was just higher than the October low, offers evidence that a trading range is forming and we are ready to set the support zone. As long as the stock trades within the boundaries set by the support and resistance zone, we will consider the trading range to be valid. Support may be looked upon as an opportunity to buy and resistance as an opportunity to sell.
Conclusion
Identification of key support and resistance levels is an essential ingredient to successful technical analysis. Even though it is sometimes difficult to establish exact support and resistance levels, being aware of their existence and location can greatly
enhance analysis and forecasting abilities. If a security is approaching an important support level, it can serve as an alert to be extra vigilant in looking for signs of increased buying pressure and a potential reversal. If a security is approaching a resistance level, it can act as an alert to look for signs of increased selling pressure and potential reversal. If a support or resistance level is broken, it signals that the relationship between supply and demand has changed. A resistance breakout signals that demand (bulls) has gained the upper hand and a support break signals that supply (bears) has won the battle.
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The Truth About Fibonacci Trading

Leonardo Fibonacci was a great Italian mathematician who lived in the thirteenth century who first observed certain ratios of a number series that are regarded as describing the natural proportions of things in the universe, including price data.  The ratios arise from the following number series:  1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144 ……
This series of numbers is derived by starting with 1 followed by 2 and then adding 1 + 2 to get 3, the third number. Then, adding 2 + 3 to get 5, the fourth number, and so on.
The ratios are derived by dividing any number in the series by the next higher number, after 3 the ratio is always 0.625.  After 89, it is always 0.618.  If you divide any Fibonacci number by the preceding number, after 2 the number is always 1.6 and after 144 the number is always 1.618.  These ratios are referred to as the “golden mean.”  Additional ratios were then derived to create ratio sets as follows:
Price Retracement Levels
0.236, 0.382, 0.500, 0.618, 0.764
Price Extension Levels
0, 0.382, 0.618, 1.000, 1.382, 1.618
The first set of ratios is used as price retracement levels and is used in trading as possible support and resistance levels.  The reason we have this expectation is that traders all over the world are watching these levels and placing buy and sell orders at these levels which becomes a self-fulfilling expectation.
The second set is used as price extension levels and is used in trading as possible profit taking levels.  Again, traders all over the world are watching these levels and placing buy and sell orders to take profits at these levels which becomes a self-fulfilling expectation.
Most good trading software packages include both Fibonacci Retracement Levels and Price Extension Levels.  In order to apply Fibonacci levels to price charts, it is necessary to identify Swing Highs and Swing Lows.  A Swing High is a short term high bar with at least two lower highs on both the left and right of the high bar.A Swing Low is a short term low bar with at least two higher lows on both the left and right of the low bar.
Fibonacci Retracement Levels
In an uptrend, the general idea is to go long the market on a retracement to a Fibonacci support level.  The price retracement levels can be applied to the price bar chart of any market by clicking on a significant Swing Low and dragging the cursor to the most recent potential Swing High and clicking there.  This will display each of the Retracement Levels showing both the ratio and corresponding price level.  Let’s take a look at some examples of markets in an uptrend.  The same points made by these examples are equally applicable to markets in a downtrend.
Example 1:  Here we plotted the Fibonacci Retracement Levels by
clicking on the Swing Low at about $71.31 and dragging the cursor to the Swing High at about $89.83.  You can see the resultant levels plotted by the software.  Now the expectation is that if the market retraces from this high it will find support at oneof the Fibonacci Levels, because traders will be placing buy orders at these levels as the market pulls back.

Example 1.1:Now let’s look at what actually happened after the Swing High occurred.  The market pulled back right through the 0.236 level and continued the next day through the 0.382 level before finding support.  After a few days, the market resumed its upward move.  Clearly buying at the 0.382 level would have been a good short term trade.
Example 2:  Again, the Fibonacci Retracement Levels were plotted on the chart in the same manner as described in Example 1.  Again, we are looking for the market to retrace from the Swing High and find support at one of the Fibonacci levels.
Example 2.1: Now let’s look at what actually happened.  The market again pulled back right through the 0.236 level and continued to pull back until it found temporary support at the 0.50 level (a lot of buyers at this level).  However, once the buying power was exhausted, the market continued to retrace all the way down to the 0.764 level before resuming its upward trend.  In this case, buying at the 0.764 level would have been a good short term trade.

Example 3:  Here’s another example.If the market retraces from the Swing High, where will it find support?

Fibonacci Price Extension Levels
In an uptrend, the general idea is to take profits on a long trade at a Fibonacci Price Extension Resistance Level.  The Price Extension Levels can be applied to the price bar chart of any market by clicking on a significant Swing Low and dragging the cursor to the most recent Swing High. Then by clicking on the Swing High and back down to the retracement Swing Low and clicking there. This will display each of the Extension Levels showing both the ratio and corresponding price level.Let’s take a look at some examples of markets in an uptrend.  The same points made by these examples are equally applicable to markets in a downtrend.
Example 5:Here we plotted the Fibonacci Price Extension Levels by clicking on the Swing Low at about $38.20 and dragged the cursor to the Swing High at about $47.67 and then down to the retracement Swing Low.  You can see the resultant levels plotted by the software.Now the expectation is that if the market continues higher it will find resistance at one of the Fibonacci Levels, because traders will be placing sell orders at these levels to take profits on there long trades.
Example 5.1:Now let’s look at what actually happened after the retracement Swing Low occurred.  The market rallied making new highs pausing at the 0.382 level and again at the 1.000 level after a retracement down it rallied again going right through the 1.382 and 1.618 levels.  Taking profits at the 0.382 level would have been premature, but taking profits at the 1.000 level would have made a nice trade.

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Symmetrical Triangle

The symmetrical triangle, which can also be referred to as a coil, usually forms during a trend as a continuation pattern. The pattern contains at least two lower highs and two higher lows. When these points are connected, the lines converge as they are extended and the symmetrical triangle takes shape. You could also think of it as a contracting wedge, wide at the beginning and narrowing over time.
While there are instances when symmetrical triangles mark important trend reversals, they more often mark a continuation of the current trend. Regardless of the nature of the pattern, continuation or reversal, the direction of the next major move can only be determined after a valid breakout. We will examine each part of the symmetrical triangle individually and then provide an example with Consesco.

1.Trend  : In order to qualify as a continuation pattern, an established trend should exist. The trend should be at least a few months old and the symmetrical triangle marks a consolidation period before continuing after the breakout.
2.4 points: At least 2 points are required to form a trendline and two trend lines are required to form a symmetrical triangle. Therefore, a minimum of 4 points are required to begin considering a formation as a symmetrical triangle. The second high (4) should be lower than the first (2) and the upper line should slope down. The second low (3) should be higher than the first (1) and the lower line should slope up. Ideally, the pattern will form with 6 points (3 on each side) before a
breakout occurs.
3.Volume:: As the symmetrical triangle extends and the trading range contracts, volume should start to diminish. This refers to the quiet before the storm, or the tightening consolidation before the breakout.
4.Duration:: The symmetrical triangle can extend for a few weeks or many months.If the pattern is less than 3 weeks, it is usually considered a pennant. Typically, the time duration is about 3 months.
5.Breakout Time frame:The ideal breakout point occurs 1/2 to 3/4 of the way through the pattern’s development or time-span. The time-span of the pattern can be measured from the apex (convergence of upper and lower lines) back to the beginning of the lower trendline (base). A break before the 1/2 way point might be premature and a break too close to the apex may be insignificant. After all, as the apex approaches, a breakout must occur sometime.
6.Breakout Direction:: The future direction of the breakout can only be determined after the break has occurred. Sound obvious enough, but attempting to guess the direction of the breakout can be dangerous. Even though a continuation pattern is supposed to breakout in the direction of the long-term trend, this is not always the case.
7.Breakout Confirmation:: For a break to be considered valid, it should be on a closing basis. Some traders apply a price (3% break) or time (sustained for 3 days) filter to confirm validity. The breakout should occur with an expansion in volume, especially on upside breakouts.
8.Return to Apex:: After the breakout (up or down), the apex can turn into future support or resistance. The price sometimes returns to the apex or a support/resistance level around the breakout before resuming in the direction of the breakout.
9.Price Target:There are two methods to estimate the extent of the move after the breakout. First, the widest distance of the symmetrical triangle can be measured and applied to the breakout point. Second, a trendline can be drawn parallel to the pattern’s trendline that slopes (up or down) in the direction of the break. The extension of this line will mark a potential breakout target.
Edwards and Magee suggest that roughly 75% of symmetrical triangles are continuation patterns and the rest mark reversals. The reversal patterns can be especially difficult to analyze and often have false breakouts. Even so, we should not anticipate the direction of the breakout, but rather wait for it to happen. Further analysis should be applied to the breakout by looking for gaps, accelerated price movements and volume for
confirmation. Confirmation is especially important for upside breakouts.
Prices sometimes return to the breakout point of apex on a reaction move before resuming in the direction of the breakout. This return can offer a second chance to participate with a better reward to risk ratio.Potential reward price targets found by measurement and parallel trendline extension are only meant to act as rough guidelines. Technical analysis is dynamic and ongoing assessment is required. In the first example above, SUNW may have fulfilled its target (42) in a few months, but the stock gave no sign of slowing down and advanced above 100 in the following months.

Conseco formed a rather large symmetrical triangle over a 5-month period before breaking out on the downside.
1.The stock declined from 50 in Mar-98 to 22 in Oct-98 before beginning to firm and consolidate. The low at 22 probably was an over-reaction, but the long-term trend was down and established for almost a year.
After the first 4 points formed, the lines of the symmetrical triangle were draw. The stock traded within the boundaries for another 2 months to form the last 2 points.
2.After the gap up from point 3 to point 4, volume slowed over the next few months. There was some increase in volume in late June, but the 60-day SMA remained in a downtrend as the pattern took shape.
3.The red square marks the ideal breakout time-span from 50% to 75% of the pattern. The breakout occurred a little over 2 weeks later, but proved valid pattern. The breakout occurred a little over 2 weeks later, but proved valid nonetheless. While it is preferable to have an ideal pattern develop, it is also quite rare.
4.After points 5 and 6 formed, the price action moved to the lower boundary of the pattern. Even at this point, the direction of the breakout was still a guess and its was prudent to wait. The break occurred with an increase in volume and accelerated price decline. Chaikin Money Flow declined past -30% and volume exceeded the 60-day SMA for an extended period.
5.After the decline from 29 1/2 to 25 1/2, the stock rebounded, but failed to reach potential resistance from the apex. The weakness of the reaction rally foreshadowed the sharpness of the decline that followed.
6.The widest point on the pattern extended 10 1/2 points. With a break of support at 29 1/2, the measured decline was estimated to around 19. By drawing a trendline parallel to the upper boundary of the pattern, the extension estimates a decline to around 20.
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Dow Theory Part 1

Introduction
The Dow theory has been around for almost 100 years, yet even in today’s volatile and technology-driven markets, the basic components of Dow theory still remain valid. Developed by Charles Dow, refined by William Hamilton and articulated by Robert Rhea, the Dow theory addresses not only technical analysis and price action, but also market philosophy. Many of the ideas and comments put forth by Dow and Hamilton became axioms of Wall Street. While there are those who may think that it is different this time, a read through The Dow Theory will attest that the stock market behaves the same today as it did almost 100 years ago.
The Dow theory presented below has been taken from Robert Rhea’s book, The Dow Theory. Although Dow theory is attributed to Charles Dow, it is William Hamilton’s writings that serve as the corner stone for this book and the development of the theory.
Also, it should be noted that most of the theory was developed with the Dow Jones Rail and Industrial averages in mind. Even though many concepts can be applied to individual stocks, please keep in mind that these are broad concepts and best applied to
stocks as a group or index. When possibly, we have also attempted to link some of the realities of today’s market with the Dow theory as explained by Dow, Hamilton and Rhea.
Background
Charles Dow developed the Dow theory from his analysis of market price action in the late 19th century. Until his death in 1902, Dow was part owner as well as editor of The Wall Street Journal. Although he never wrote a book on the subject, he did write
some editorials that reflected his views on speculation and the role of the rail and industrial averages.
Even though Charles Dow is credited with developing the Dow theory, it was S.A. Nelson and William Hamilton who later refined the theory into what it is today. Nelson wrote The ABC of Stock Speculation and was the first to actually use the term “Dow
theory.” Hamilton further refined the theory through a series of articles in The Wall Street Journal from 1902 to 1929. Hamilton also wrote The Stock Market Barometer in 1922, which sought to explain the theory in detail.
In 1932, Robert Rhea further refined the analysis of Dow and Hamilton in The Dow Theory
. Rhea read, studied and deciphered some 252 editorials through which Dow (1900-1902) and Hamilton (1902-1929) conveyed their thoughts on the market. Rhea
also referred to Hamilton’s The Stock Market Barometer. The Dow Theory presents the Dow theory as a set of assumptions and theorems.
Averages Discount Everything
The market reflects all available information. Everything there is to know is already reflected in the markets through the price. Prices represent the sum total of all the hopes, fears and expectations of all participants. Interest rate movements, earnings
expectations, revenue projections, presidential elections, product initiatives and all else are already priced into the market. The unexpected will occur, but usually this will affect the short-term trend. The primary trend will remain unaffected.The chart below of Coca-Cola is a recent example of the primary trend remaining intact. The downtrend for Coca-Cola began with the sharp fall from above 90. The stock rallied with the market in October and November 1998, but by December started to decline again. According to Dow Theory, the October/November rally would be called a secondary move (against the primary trend). It is likely that the stock was caught up in the general market advance at the time. However, when the major indices were hitting new highs in December, Coca-Cola was starting to flounder and resume its primary trend.

Hamilton noted that sometimes the market would react negatively to good news. For Hamilton, the reasoning was simple: the market looks ahead. By the time the news hits the street, it is already reflected in the price. This explains the old Wall Street axiom, “buy the rumor, sell the news”. As the rumor begins to filter down, buyers step in and bid the price up. By the time the news hits, the price has been bid up to fully reflect the news. Yahoo! and the run up to earnings is a classic example. For the past three quarters, Yahoo! has been bid up leading right up to the earnings report. Even though earnings have exceeded expectations each time, the stock has fallen by about 20%.

Theory Not Perfect
Hamilton and Dow readily admit that the Dow theory is not a sure-fire means of beating the market. It is looked upon as a set of guidelines and principles to assist investors and traders with their own study of the market. The Dow theory provides a mechanism for investors to use that will help remove some of the emotion. Hamilton warns that investors should not be influenced by their own wishes. When analyzing the market, make sure you are objective and see what is there, not what you want to see. If an investor is long, he or she may want to see only the bullish signs and ignore any bearish signals. Conversely, if an investor is out of the market or short, he or she may be apt to focus on the negative aspects of the price action and ignore any bullish developments. Dow Theory provides a mechanism to help make decisions less ambiguous. The methods for identifying the primary trend are clear-cut and not open to interpretation.Even though the theory is not meant for short-term trading, it can still add value for traders. No matter what your time frame, it always helps to be able to identify the primary trend. According to Hamilton (writing in the early part of the 20th century), those who successfully applied the Dow theory rarely traded more than four or five times a year. Remember that intraday, day-to-day and possibly even secondary movements can be prone to manipulation, but the primary trend is immune from manipulation. Hamilton and Dow sought a means to filter out the noise associated with daily fluctuations. They were not worried about a couple of points, or getting the exact top or bottom. Their main concern was catching the large moves. Both Hamilton and
Dow recommended close study of the markets on a daily basis, but they also sought to minimize the effects of random movements and concentrate on the primary trend. It is easy to get caught up in the madness of the moment and forget the primary trend. After the October low, the primary trend for Coca-Cola remained bearish. Even though there were some sharp advances, the stock never forged a higher high.
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Moving Averages

If price movements are choppy and erratic over an extended period of time, then a moving average is probably not the best choice for analysis. The chart for MMM shows a security that moved from 70 to 90 in a few weeks in late April. Prior to this advance, the price gyrated above and below its moving average. After the advance, the stock continued its erratic behavior without developing much of a trend. Trying to analyze this security based on a moving average is likely to be a lesson in futility.

AOL

A quick look at the chart for AOL shows a different picture than for MMM. Over the same time period, AOL has shown the ability to trend. There are 3 distinct trends or price movements that extend for a number of months. Once the stock moves above or below the 70-day SMA, it usually continues in that direction for a little while longer. MMM, on the other hand, broke above and below its 70-day SMA numerous times and would have been prone to numerous whipsaws. A longer moving average would probably work better for MMM, but it is clear that there are fewer characteristics of trend than in AOL.
Moving Average Settings
Once a security has been deemed to have enough characteristics of trend, the next task will be to select the number of moving average periods and type of moving average. The number of periods used in a moving average will vary according to the security’s volatility, trendiness and personal preferences. The more volatility there is, the more smoothing that will be required and hence the longer the moving average. Stocks that do not exhibit strong characteristics of trend may also require longer moving averages. There is no one set length, but some of the more popular lengths include 21, 50, 89, 150 and 200 days as well as 10, 30 and 40 weeks. Short-term traders may look for evidence of 2-3 week trends with a 21-day moving average, while longer-term investors may look for evidence of 3-4 month trends with a 40-week moving average. Trial and error is usually the best means for finding the best length. Examine how the moving average fits with the price data. If there are too many breaks, lengthen the moving average to decrease its sensitivity. If the moving average is slow to react, shorten the moving average to increase its sensitivity. In addition, you may want to try using both simple and exponential moving averages. Exponential moving averages are usually best
for short-term situations that require a responsive moving average. Simple moving averages work well for longer-term situations that do not require a lot of sensitivity.
Uses for Moving Averages
There are many uses for moving averages, but three basic uses stand out:
Trend identification/confirmation
Support and Resistance level identification/confirmation
Trading Systems
Trend Identification/ConfirmationThere are three ways to identify the direction of the trend with moving averages: direction, location and crossovers.
The first trend identification technique uses the direction of the moving average to determine the trend. If the moving average is rising, the trend is considered up. If the moving average is declining, the trend is considered down. The direction of a moving average can be determined simply by looking at a plot of the moving average or by applying an indicator to the moving average. In either case, we would not want to act
on every subtle change, but rather look at general directional movement and changes.

Disney
In the case of Disney, a 100-day exponential moving average (EMA) has been used to determine the trend. We do not want to act on every little change in the moving average, but rather significant upturns and downturns. This is not a scientific study, but a number of significant turning points can be spotted just based on visual observation
(red circles). A few good signals were rendered, but also a few whipsaws and late signals. Much of the performance would depend on your entry and exit points. The length of the moving average influences the number of signals and their timeliness. Moving averages are lagging indicators. Therefore, the longer the moving average is,
the further behind the price movement it will be. For quicker signals, a 50-day EMA could have been used.
The second technique for trend identification is price location. The location of the price relative to the moving average can be used to determine the basic trend. If the price is above the moving average, the trend is considered up. If the price is below the moving average, the trend is considered down.
This example is pretty straightforward. The long-term for ENE is determined by the location of the stock relative to its 100-day SMA. When ENE is above its 100-day SMA, the trend is considered bullish. When the stock is below the 100-day SMA, the trend is considered bearish. Buy and sell signals are generated by crosses above and below themoving average. There was a brief sell signal generated in Aug-98 and a false buy
signal in Nov-99. Both of these signals occurred when Enron’s trend began to weaken. For the most part though, this simple method would have kept an investor in throughout most of the bull move.
The third technique for trend identification is based on the location of the shorter moving average relative to the longer moving average. If the shorter moving average is above the longer moving average, the trend is considered up. If the shorter moving average is below the longer moving average, the trend is considered down.
Support and Resistance Levels
Another use of moving averages is to identify support and resistance levels. This is usually accomplished with one moving average and is based on historical precedent. As with trend identification, support and resistance level identification through moving averages works best in trending markets.

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BOLLINGER BANDS

Bollinger Bands are similar to moving average envelopes. The difference between Bollinger Bands and envelopes is envelopes are plotted at a fixed percentage above and below a moving average, whereas Bollinger Bands are plotted at standard deviation levels above and below a moving average. Since standard deviation is a measure of volatility, the bands are self-adjusting: widening during volatile markets and contracting during calmer periods.
Bollinger Bands were created by John Bollinger.
Interpretation
Bollinger Bands are usually displayed on top of security prices, but they can be displayed on an indicator. These comments refer to bands displayed on prices.
As with moving average envelopes, the basic interpretation of Bollinger Bands is that prices tend to stay within the upper- and lower-band. The distinctive characteristic of Bollinger Bands is that the spacing between the bands varies based on the volatility of the prices. During periods of extreme price changes (i.e., high volatility), the bands widen to become more forgiving. During periods of stagnant pricing (i.e., low volatility), the bands narrow to contain prices.
Mr. Bollinger notes the following characteristics of Bollinger Bands.Sharp price changes tend to occur after the bands tighten, as volatility lessens.
When prices move outside the bands, a continuation of the current trend is implied.
Bottoms and tops made outside the bands followed by bottoms and tops made inside the bands call for reversals in the trend.
A move that originates at one band tends to go all the way to the other band. This observation is useful when projecting price targets.
Example
The following chart shows Bollinger Bands on Exxon’s prices.

The Bands were calculated using a 20-day exponential moving average and are spaced two deviations apart.The bands were at their widest when prices were volatile during April. They narrowed when prices entered a consolidation period later in the year. The narrowing of the bands increases the probability of a sharp breakout in prices. The longer prices remain within the narrow bands the more likely a price breakout.
Calculation
Bollinger Bands are displayed as three bands. The middle band is a normal moving average. In the following formula, “n” is the number of time periods in the moving average (e.g., 20 days).

The upper band is the same as the middle band, but it is shifted up by the number of standard deviations (e.g., two deviations). In this next formula, “D” is the number of standard deviations.

The lower band is the moving average shifted down by the same number of standard deviations (i.e., “D”).

Mr. Bollinger recommends using “20″ for the number of periods in the moving average, calculating the moving average using the “simple” method (as shown in the formula for the middle band), and using 2 standard deviations. He has also found that moving averages of less then 10 periods do not work very well.

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ABSOLUTE BREADTH INDEX

The Absolute Breadth Index (“ABI”) is a market momentum indicator that was developed by Norman G. Fosback.The ABI shows how much activity, volatility, and change is taking place on the New York Stock Exchange while ignoring the direction prices are headed.
Interpretation
You can think of the ABI as an “activity index.” High readings indicate market activity and change, while low readings indicate lack of change.
In Fosback’s book, Stock Market Logic, he indicates that historically, high values typically lead to higher prices three to twelve months later. Fosback found that a highly reliable variation of the ABI is to divide the weekly ABI by the total issues traded. A ten-week moving average of this value is then calculated. Readings above 40% are very bullish and readings below 15% are bearish.
Example

The following chart shows the S&P 500 and a 5-week moving average of the ABI.

Strong rallies occurred every time the ABI’s moving average rose above 310.
Calculation
The Absolute Breadth Index is calculated by taking the absolute value of the difference between NYSE Advancing Issues and NYSE Declining Issues.
ABS(Advancing Issues-Declining Issues)
Absolute value (i.e., ABS) means “regardless of sign.” Thus, the absolute value of -100 is 100 and the absolute value of +100 is also 100.

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INDICATORS

Indicators
An indicator is a mathematical calculation that can be applied to a security’s price and/or volume fields. The result is a value that is used to anticipate future changes in prices.
A moving average fits this definition of an indicator: it is a calculation that can be performed on a security’s price to yield a value that can be used to anticipate future changes in prices. I’ll briefly review one simple indicator here, the Moving Average Convergence Divergence (MACD).
MACD
The MACD is calculated by subtracting a 26-day moving average of a security’s price from a 12-day moving average of its price. The result is an indicator that oscillates above and below zero.
When the MACD is above zero, it means the 12-day moving average is higher than the 26-day moving average. This is bullish as it shows that current expectations (i.e., the 12-day moving average) are more bullish than previous expectations (i.e., the 26-day average). This implies a bullish, or upward, shift in the supply/demand lines. When the MACD falls below zero, it means that the 12-day moving average is less than the 26-day moving average, implying a bearish shift in the supply/demand lines.
Figure 28 shows Autozone and its MACD. I labeled the chart as “Bullish” when the MACD was above zero and “Bearish” when it was below zero. I also displayed the 12- and 26-day moving averages on the price chart.

A 9-day moving average of the MACD (not of the security’s price) is usually plotted on top of the MACD indicator. This line is referred to as the “signal” line. The signal line anticipates the convergence of the two moving averages (i.e., the movement of the MACD toward the zero line).
The chart in Figure  shows the MACD (the solid line) and its signal line (the dotted line). “Buy” arrows were drawn when the MACD rose above its signal line; “sell” arrows were drawn when the MACD fell below its signal line.

Let’s consider the rational behind this technique. The MACD is the difference between two moving averages of price. When the shorter-term moving average rises above the longer-term moving average (i.e., the MACD rises above zero), it means that investor expectations are becoming more bullish (i.e., there has been an upward shift in the supply/demand lines). By plotting a 9-day moving average of the MACD, we can see the changing of expectations (i.e., the shifting of the supply/demand lines) as they occur.
Leading versus lagging indicators
Moving averages and the MACD are examples of trend following, or “lagging,” indicators. \[See Figure .] These indicators are superb when prices move in relatively long trends. They don’t warn you of upcoming changes in prices, they simply tell you what prices are doing (i.e., rising or falling) so that you can invest accordingly. Trend following indicators have you buy and sell late and, in exchange for missing the early opportunities, they greatly reduce your risk by keeping you on the right side of the market.

As shown in Figure , trend following indicators do not work well in sideways markets.
Trending prices versus trading prices
There have been several trading systems and indicators developed that determine if prices are trending or trading. The approach is that you should use lagging indicators during trending markets and leading indicators during trading markets. While it is relatively easy to determine if prices are trending or trading, it is extremely difficult to know if prices will trend or trade in the future.

Divergences

A divergence occurs when the trend of a security’s price doesn’t agree with the trend of an indicator. Many of the examples in subsequent chapters demonstrate divergences.

The chart in Figure 34 shows a divergence between Whirlpool and its 14-day CCI (Commodity Channel Index). \[See page .] Whirlpool’s prices were making new highs while the CCI was failing to make new highs. When divergences occur, prices usually change direction to confirm the trend of the indicator as shown in Figure 34. This occurs because indicators are better at gauging price trends than the prices themselves.

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Charting the Trend

What It Means to Be a Trend Follower
A trend followerbuys when the price trend is up and sells when the pricetrend is down. A trend follower believes that, if the trend is up then it willcontinue to go up; therefore, trend followers make the assumption thattrends persist. If everything works as expected, the trend continues longenough to yield a profitable trade.Why Should the Trend Continue?There’s good reason why the trend persists.Most trends are the result of  government economic policy. In the U.S. the Federal Reserve (Fed) targetsan economic growth of 3 percent. In order to accomplish that in a bad econ-omy, they will lower interest rates. First they lower rates by 0.5 percent to seehow the economy reacts. Then they lower rates by another 0.5 percent and watch Figures.This process of ratcheting down interest .

FIGURE
Interest rates drive the stock market.Top: 10-year notes continuationseries. Bottom: S&P 500 Index. There’s a clear relationship between interest rates and the stock respond. T-note prices begin going up in January 2000 (interest rates declining), but the stock market has not yet reacted.rates causes a trend in all of the markets that depend on rates and all com-panies that have debt-which is pretty nearly all of them The biggest trends usually begin with a change in interest rates. Some-times, the beginning can be a change in the value of the U.S. dollar. The dol-lar can drop when the U.S. imports much more than it exports. When you buyforeign products, you buy their currency as well.
Expectation
also drives prices. Will a hot summer cause a shortage ofelectricity, or a shortage of water? Will a weakening economy reduce the
number of airline passengers and shorten hotel stays? Will the economystrengthen or weaken? These events don’t occur overnight;they evolve gradually .Prices rise and fall in anticipation.
Courtesy CopyrightTechnical trading.com .This content copyrights protected  Written by  Pery J. Kaufmam.

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