Accep tability of the trend forecasting model using the time series analysis of stock indices

The researcher has more than five years of experience in stock trading in the Vietnam market and realizes the efficiency of technical analysis, which uses a number of core calculations b

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A DISSERTATION Presented to the Faculty of the Graduate School Southern Luzon State University, Lucban, Quezon, Philippines

in Collaboration with Thai Nguyen University, Socialist Republic of Vietnam

Chapter 1 INTRODUCTION

To industrialize and modernize the country requires an effort to maintain stable economic growth and restructure the economy to enhance its efficiency and competitiveness, Vietnam needs huge capital investment Therefore, building the securities market in Vietnam has become an urgent need to mobilize mid-term and long-term capital within, as well as outside the country into economic investment through debt and capital securities In addition, equitization of state-owned enterprises along with the establishment and development of the securities market has created a more open and healthy business environment

On July 10, 1998, the Prime Minister signed Decree No

48/1998/ND-CP on the stock and securities market and a decision to set up two securities trading centers in Hanoi and Ho Chi Minh City (The Vietnam STATE SECURITIES COMMISSION (SSC), 2012) On July 20th 2000, the Ho Chi Minh City Securities Trading Center officially commenced operation and executed the first trading session on July 28, 2000 with two types of listing stocks

After seven years of growth and integration into the global securities market, the government signed Decision No 599/QD-TTg on May 11, 2007 to transfer the Ho Chi Minh City Securities Trading Center to Hochiminh Stock Exchange (HOSE) On August 8, 2007, Hochiminh Stock Exchange was officially opened

Hanoi Stock Exchange (HNX) was established by Decision no 01/2009/QĐ-Ttg dated January 02, 2009 by the Prime Minister of Vietnam on the grounds of transforming and restructuring Hanoi Securities Trading Centre Hanoi Securities Trading Centre (HASTC), which was founded in compliance with Decision No.127/1998/QĐ-TTg dated July 11, 1998, has gone live since 2005 organizing share auctions and bond biddings It also provides a secondary market for both stocks and bonds as its major activities

Hochiminh Stock Exchange has experienced encouraging growth On August 31, 2012, it has listed 303 stocks with a total capitalization value of VND 154,137,023.19 billion and Hanoi Stock Exchange (HNX) has listed 397 stocks with a total listed value of VND 84,511,094.02 billion (The Vietnam STATE SECURITIES COMMISSION (SSC), 2012 ) In the near future, the number of listed stocks on HOSE and HNX will increase quickly because the government has a policy to equitize a number of large companies and state-owned commercial banks which will be listed in the market

The primary purpose of this research was to assess the Time Series Analysis Model which the researcher has developed to help investors know how to recognize the trend of the market and to provide objectiveness in the decision-making process There are more than 700 stocks (State Securities Commission of Vietnam, 2012) for investors to choose from and this research will help investors to make an informed decision when they take actions to buy or sell stocks In Vietnam, the traders mostly buy or sell by emotion or rumors especially individual investors, therefore they almost always make a low profit or a loss

There are many technical indicators to support investor decision but these six indicators that the author used to build the Time Series Analysis Model have not been combined in any model before, and so their usefulness

as a combined set of indicators has not yet been identified

The researcher has more than five years of experience in stock trading

in the Vietnam market and realizes the efficiency of technical analysis, which uses a number of core calculations based on statistical functions such as Simple Moving Average, Exponential Moving Average (EMA), simple moving average plus 2 standard deviations, and simple moving average minus 2 standard deviations This research will apply statistical functions to find the trend of Hose and Hnx and to support trading decisions

Background of the Study

Normally, the respondents would need to consider the following questions, so that they can not only make trading decisions, but also assess any trend prediction model that they use:

1 What is the current trend of the Vietnam stock index?

3.3 Wait and hold the money

The TSA Model is designed to assist the investor to answer these questions

Currently some investors do not use any model, and of those that do use a model, the indicators are often used separately and sometimes these indicators are used incorrectly There are about 2000 technical indicators and most investors usually do not know what the indicator means, how to use the indicator exactly, or how to combine the technical indicator in trading stock For stockbrokers, they use a variety of indicators, but they do not have a comprehensive model that uses such a broad range of indicators together It

is expected that the TSA Model will improve this situation for both investors and stockbrokers

The 2005-2009 period is considered as an acceleration phase of the Vietnam stock market with breakthrough growth The rate of capitalization/GDP far exceeded the development strategy of the market by

2010 (at 10-15% of GDP) (Source: Vietnam State Securities Committee, 2012)

With the market size in this period the number of securities companies and investors also grew strongly In 2000, there six were only s securities companies with capital stock average no more than VND 50 billion and by the end of 2009 there were 105 securities companies with average capital of VND

175 billion, of which some of the larger companies were JSC Saigon Securities (SSI) with VND 1,000 billion and ACB Securities (ACBS) with VND 1,500 billion

During this period, in addition to growth, the stock market also experienced a strong change in management when the Securities Law took effect in January 2007 In 2007, HCM City Securities Trading Center was transformed into Ho Chi Minh City Stock Exchange (HOSE) to make it more active in management, contributing to market development In 2008, although Vietnam's stock market was heavily influenced by the global economic downturn, the average transaction volume in HOSE remained at 13 million units/session, deploying online transactions, joint continuous orders contributing to the operation of market transactions In 2009, the policies of government stimulus and signs of economic recovery helped the market to flourish again By the end of 2009, the total market capitalization was 620 trillion, equivalent to 38% of GDP (State securities commission of Vietnam, 2012)

In the last three years, the boom is Vietnam's stock market has fed a storm of forecasts about market trends, stock prices and recommendations to

buy, sell or hold specific stocks So much information has become "disturbing"

to investors, resulting to investors not knowing what they should do If they make decisions following this plethora of advice, they will always lose So how can investor build an appropriate strategy, and make the correct trading decisions?

Particularly dangerous are forecasts made by word of mouth, via mail, telephone, message broker, analyst, consultant companies and securities investment companies, because this wave spreads information as fast as "oil slick" Currently, there are many ways to analyze and forecast rumored style, jamming, and even forecast nature impose for on investor psychology, leading investors grab market share or attempt situations that create misunderstandings and major; distortions of the stock market in order

e-to profit

The Vietnam stock market has flourished both in number of listed stocks and the quality of shares listed over time This is good opportunity for stock investors, but it is also quite risky if investors are not equipped with the right knowledge and proper investment strategy Having all these premises in mind, the researcher attempted to apply his knowledge of probability statistics into technical analysis to help investors identify the trend of the Vietnam stock market index and to support their trading decisions

Objectives of the Study

The main purpose of this research was to assess the acceptability of the Time Series Analysis Model using six statistical indicators of the trend of

the Vietnam stock index trend and apply these indicators to each separate stock to help investors make trading decisions (buy/sell/hold)

To assess the usefulness of the TSA Model in terms of:

1 Profile of the respondents

2 Reliability

3 Efficiency

4 Availability of required software and input data?

5 Level of acceptability do you experience when you use the TSA model in assisting you to make investment decisions?

Hypothesis of the Study

1 The hypothesis itself is a null hypothesis, ―There is no significant difference in the level of perceptions among the groups of respondents‖ The model uses six nominated indicators to predict price rises and price falls on the Hose and HNX stock exchanges of Vietnam The respondents are assessing the reliability and usefulness

of the Time Series Analysis Model for decision making for trading actions (buy/sell/hold)

2 The level of acceptability of the trend forecasting model using the Time Series Analysis of stock indices is dependent and affected by the reliability, efficiency and availability variables

Significance of the Study

This study which aimed to assess the perceptions of users of the TSA Model, used the model to discover the trends of the Vietnam stock index by

using time series analysis in technical analysis and in supporting trading decisions This study would be beneficial to the following:

Stock investors It is hoped that the study may contribute to more

informed decisions for traders In stock investment, the action to buy, sell or wait is a vital decision but the challenge for the investor is to find the proper point for trading This research will give the trader a tool or an analysis method to find the trading point for stocks in the Vietnam stock market

Stock Analysis Teachers The outcome of the study may be of great

help to teachers of stock analysis as they will gain more understanding in the use of technical analysis using time series analysis for stock trading The researcher may contribute to a new avenue in his search for better ways to improve oneself and the work environment In this way, it would ultimately lead to a more efficient trading in the teaching of stock analysis

Finance Students They will benefit from this study since their main

concerns in technical analysis are what they can apply in stock investment or commodities trading by analyzing historical data The researcher hopes that the results and findings of the study will bring understanding and inspiration to students to further study this field

Future Researchers This study could provide a reference for future

proponents who wish to venture into a study related to this ongoing research Thus, using time series in technical analysis of stock trading could serve as a valuable resource for future studies

Scope and Limitation of the Study

The primary aim of this study was to assess the reliability and usefulness of the TSA Model, which applies time series analysis in technical analysis to identify the trend of the Vietnam stock index and support trading decisions

This research surveyed a limited number of investors and stockbrokers, and thus it gave the perceptions of a sample of the investment trading community, it did not give the broad perceptions of the whole investment trading industry

The model uses the historic data of the Vietnam stock index including: Vnindex for Hose and Hnindex for HNX from the years 2007 to 2013 About seven hundred (700) stocks were used as respondents in this study

The use of time series analysis for technical analysis in this research included the following instructional variables: open price, high price, low price, close price, volume and date of trading

The limitation of using time series analysis for forecasting the trend of stock market and for supporting trading decisions is that it can be dangerous

to depend totally on the assumption that today's prices can predict future prices They often do, but not necessarily

The time frame of this study covered from March 2011 to March 2013

Definition of Terms

For clarity and better understanding of this study, the following terms were hereby defined conceptually and operationally:

Acceptability the level of acceptance of the TSA Model by investors

Back testing the process of testing a trading strategy on prior time

periods Instead of applying a strategy for the time period forward, which could take years, a trader can do a simulation of his or her trading strategy on relevant past data in order to gauge its effectiveness

Bear Market a market condition in which the prices of securities are

falling, and widespread pessimism causes the negative sentiment to be sustaining As investors anticipate losses in a bear market and selling continues, pessimism only grows Although figures can vary, for many, a downturn of 20% or more in multiple broad market indices such as the Dow Jones Industrial Average (DJIA) or Standard & Poor's 500 Index (S&P 500)

self-over at least a two-month period is considered an entry into a bear market

Bull Market a financial market of a group of securities in which prices

are rising or are expected to rise The term "bull market" is most often used to refer to the stock market, but can be applied to anything that is traded, such

as bonds, currencies and commodities

Close price is the last price that the security traded for the day Due to

its availability, the Close is the most often used price for analysis The relationship between the Open (the first price) and the Close (the last price)

are considered significant by most technicians This relationship is emphasized in candlestick charts

Correction a reverse movement, usually negative, of at least 10% in a

stock, bond, commodity or index Corrections are generally temporary price declines, interrupting an uptrend in the market or asset

Date the day that has the data on the stock price open, high price, low price and closed price

Downtrend is the price movement of a financial asset when the

overall direction is downward A formal downtrend occurs when each successive peak and trough is lower than the ones found earlier in the trend

Figure 1 Downtrend Price Movement

Source: http://www.investopedia.com

High price is the highest price that the security traded on the day It is

the point at which there were more sellers than buyers (i.e., there are always sellers willing to sell at higher prices, but the High represents the highest price buyers were willing to pay)

Low price is the lowest price that the security traded on the day It is

the point at which there were more buyers than sellers (i.e., there are always buyers willing to buy at lower prices, but the Low represents the lowest price sellers were willing to accept)

Overbought

1 A situation in which the demand for a certain asset unjustifiably pushes the price of an underlying asset to levels that do not support the fundamentals

2 In technical analysis, this term describes a situation in which the price of a security has risen to such a degree - usually on high volume - that

an oscillator has reached its upper bound This is generally interpreted as a sign that the price of the asset is becoming overvalued and may experience a pullback

Open price is the price of the first trade of the day When analyzing

daily data, the Open is especially important, as it is the consensus price after all interested parties were able to "sleep on it."

Oversold

1 A condition in which the price of an underlying asset has fallen sharply, and to a level below which its true value resides This condition is usually a result of market overreaction or panic selling

2 A situation in technical analysis where the price of an asset has fallen to such a degree, usually on high volume, that an oscillator has reached

a lower bound This is generally interpreted as a sign that the price of the

asset is becoming undervalued and may represent a buying opportunity for investors

Resistance (Resistance Level) the price at which a stock or market

can trade, but not exceed, for a certain duration

Figure 2 Resistance Level

Source: http://www.investopedia.com

Retracement a temporary reversal in the direction of a stock's price

that goes against the prevailing trend A retracement does not signify a change in the larger trend On a chart where a stock's price is generally headed upward, retracements are the small dips in price that the stock experiences during its overall upward trend Whether an investor identifies a change in a stock's direction as a retracement or a reversal will impact how he responds to it

Figure 3 Retracement

Source: http://www.investopedia.com

Sideways Trend is the horizontal price movement that occurs when

the forces of supply and demand are nearly equal A sideways trend is often regarded as a period of consolidation before the price continues in the direction of the previous move A sideways price trend is also commonly known as a "horizontal trend"

Support Level the price level, which, historically, a stock has had

difficulty falling below It is thought of as the level at which a lot of buyers tend

to enter the stock It often referred to as the "support level"

Technical analysis a method of evaluating securities by analyzing

statistics generated by market activity, such as past prices and volume Technical analysts do not attempt to measure a security's intrinsic value, but instead use charts and other tools to identify patterns that can suggest future activity

Figure 4 Support Level

Source: http://www.investopedia.com

Time Series Analysis is the analysis that uses the efficiency of

technical analysis, which uses a number of core calculations based on statistical functions for the past trading data of stock price and volume such as Simple moving average, Exponential moving average (EMA), simple moving average plus two standard deviations, and simple moving average minus two standard deviations And how to apply the statistical functions to find the trend

of stock indices and to support trading decisions

Stock indices In Vietnam, there are two stock indices: Vn index and

Hnx index A stock index or stock market index is a method of measuring the value of a section of the stock market It is computed from the prices of

selected stocks (sometimes a weighted average)

Trend the general direction of a market or of the price of a stock

Trends can vary in length from short, to intermediate, to long term If you can identify a trend, it can be highly profitable, because you will be able to trade with the trend

Uptrend is the price movement of a financial asset when the overall

direction is upward A formal uptrend is when each successive peak and trough is higher than the ones found earlier in the trend

Figure 5 Uptrend

Source: http://www.investopedia.com

Volume is the number of shares that were traded on the day The

relationship between prices and volume (e.g., increasing prices accompanied with increasing volume) is important

Chapter II

REVIEW OF LITERATURE

This chapter includes several publications related to the technical analysis of stocks and the use of technical indicators to support stocks trading Technical analysis is a discipline for analyzing and forecasting the direction of the prices of securities through the study of previous market data, primarily price and volume A fundamental principle of technical analysis is that a market's price reflects all relevant information, so the analysis looks at the history of a security's trading pattern rather than external drivers such as economics, fundamentals and news events Price action also tends to repeat itself because investors collectively tend toward patterned behavior, hence, technicians' focus on identifiable trends and conditions

The Dow Theory is the grandfather of all technical market studies The Dow Theory on stock price movement is a form of technical analysis that includes some aspects of sector rotation The theory was derived from 255 Wall Street Journal editorials written by Charles H Dow (1851–1902), journalist, founder and first editor of the Wall Street Journal and co-founder of Dow Jones and Company Following Dow's death, William Peter Hamilton, Robert Rhea and E George Schaefer organized and collectively represented Dow Theory, based on Dow's editorials The six basic tenets of Dow Theory

as summarized by Hamilton, Rhea, and Schaefer are described below

Six basic tenets of Dow Theory

 The market has three movements

(1) The "main movement", primary movement or major trend may last from less than a year to several years It can be bullish or bearish (2) The

"medium swing", secondary reaction or intermediate reaction may last from ten days to three months and generally retraces from 33% to 66% of the primary price change since the previous medium swing or start of the main movement (3) The "short swing" or minor movement varies with opinion from hours to a month or more The three movements may be simultaneous, for instance, a daily minor movement in a bearish secondary reaction within a bullish primary movement

 Market trends have three phases

Dow Theory asserts that major market trends are composed of three phases: an accumulation phase, a public participation phase, and a distribution phase The accumulation phase (phase 1) is a period when investors "in the know" are actively buying (selling) stock against the general opinion of the market During this phase, the stock price does not change much because these investors are in the minority demanding (absorbing) stocks that the market at large is supplying (releasing) Eventually, the market catches on to these astute investors and a rapid price change occurs (phase 2) This occurs when trend followers and other technically oriented investors participate This phase continues until rampant speculation occurs At this

point, the astute investors begin to distribute their holdings to the market (phase 3)

 The stock market discounts all news

Stock prices quickly incorporate new information as soon as it becomes available Once news is released, stock prices will change to reflect this new information On this point, Dow Theory agrees with one of the premises of the efficient market hypothesis

 Stock market averages must confirm each other

In Dow's time, the US was a growing industrial power The US had population centers but factories were scattered throughout the country Factories had to ship their goods to market, usually by rail Dow's first stock averages were an index of industrial (manufacturing) companies and rail companies To Dow, a bull market in industrials could not occur unless the railway average rallied as well, usually first According to this logic, if manufacturers' profits are rising, it follows that they are producing more If they produce more, then they have to ship more goods to consumers Hence,

if an investor is looking for signs of health in manufacturers, he or she should look at the performance of the companies that ship the output of them to market, the railroads The two averages should be moving in the same direction When the performance of the averages diverges, it is a warning that change is in the air

Both Barron's Magazine and the Wall Street Journal still publish the daily performance of the Dow Jones Transportation Index in chart form The

index contains major railroads, shipping companies, and air freight carriers in the US

 Trends are confirmed by volume

Dow believed that volume confirmed price trends When prices move

on low volume, there could be many different explanations An overly aggressive seller could be present for example But when price movements are accompanied by high volume, Dow believed this represented the "true" market view If many participants are active in a particular security, and the price moves significantly in one direction, Dow maintained that this would be the direction in which the market anticipated continued movement To him, it was a signal that a trend is developing

 Trends exist until definitive signals prove that they have ended

Dow believed that trends existed despite "market noise" Markets might temporarily move in the direction opposite to the trend, but they will soon resume the prior move The trend should be given the benefit of the doubt during these reversals Determining whether a reversal is the start of a new trend or a temporary movement in the current trend is not easy Dow Theorists often disagree in this determination Technical analysis tools attempt to clarify this but they can be interpreted differently by different investors

Nowadays, the Dow Theory remains the fundamental basic framework for technical analysis and technical indicators A market trend is a putative tendency of a financial market to move in a particular direction over time The

―Use of Trend‖, written by Cory Janssen, Chad Langager and Casey Murphy, shows that trend is one of the most important concepts in technical analysis The meaning in finance isn't all that different from the general definition of the term, a trend is really nothing more than the general direction in which a security or market is headed For example, see the chart below: It isn't hard to see that the trend in the above Figure is up However, it's not always this easy

to see a trend:

Figure 6 Clear trend

Figure 7 Unclear trend

There are lots of ups and downs in this chart, but there isn't a clear indication of which direction this security is headed Unfortunately, trends are not always easy to see In other words, defining a trend goes well beyond the obvious In any given chart, you will probably notice that prices do not tend to move in a straight line in any direction, but rather in a series of highs and lows In technical analysis, it is the movement of the highs and lows that constitutes a trend For example, an uptrend is classified as a series of higher highs and higher lows, while a downtrend is one of lower lows and lower highs

Types of Trend

There are three types of trend: Uptrends, Downtrends and Sideways/Horizontal Trends As the names imply, when each successive peak

and trough is higher, it's referred to as an upward trend If the peaks and troughs are getting lower, it's a downtrend When there is little movement up

or down in the peaks and troughs, it's a sideways or horizontal trend If you want to get really technical, you might even say that a sideways trend is actually not a trend on its own, but a lack of a well-defined trend in either direction In any case, the market can really only trend in these three ways:

up, down or nowhere

Trend Lengths

Along with these three directions, there are three trend classifications

A trend of any direction can be classified as a long-term trend, intermediate trend or a short-term trend In terms of the stock market, a major trend is generally categorized as one lasting longer than a year An intermediate trend

is considered to last between one and three months and a near-term trend is anything less than a month A long-term trend is composed of several intermediate trends, which often move against the direction of the major trend

If the major trend is upward and there is a downward correction in price movement followed by a continuation of the uptrend, the correction is considered to be an intermediate trend The short-term trends are components of both major and intermediate trends Take a look the below Figure to get a sense of how these three trend lengths might look

Figure 8 Trend Length

When analyzing trends, it is important that the chart is constructed to best reflect the type of trend being analyzed To help identify long-term trends, weekly charts or daily charts spanning a five-year period are used by chartists

to get a better idea of the long-term trend Daily data charts are best used when analyzing both intermediate and short-term trends It is also important to remember that the longer the trend, the more important it is; for example, a one-month trend is not as significant as a five-year trend

clearly show the trend and are also used in the identification of trend reversals

As can be seen in Figure 9, an upward trend line is drawn at the lows

of an upward trend This line represents the support the stock has every time

it moves from a high to a low Notice how the price is propped up by this support This type of trend line helps traders to anticipate the point at which a stock's price will begin moving upwards again Similarly, a downward trend line is drawn at the highs of the downward trend This line represents the resistance level that a stock faces every time the price moves from a low to a high

Figure 9 Trend Line

Figure 10 Channels

The above Figure illustrates a descending channel on a stock chart; the upper trend line has been placed on the highs and the lower trend line is

on the lows The price has bounced off these lines several times, and has remained range-bound for several months As long as the price does not fall below the lower line or move beyond the upper resistance, the range-bound downtrend is expected to continue

The authors explain the importance of understanding and identifying trends so that you can trade with rather than against them Two important sayings in technical analysis are "the trend is your friend" and "don't buck the trend," illustrating how important trend analysis is for technical traders

Support and Resistance

In the book ―Technical Charting for Profits‖, Larson and Mark (2001) pointed out that it is easy to define Support and Resistance Levels by viewing chart patterns of stocks or indexes These and many other patterns have become very valuable when determining when to buy and sell investments Support and Resistance Levels are simple indicators that can show a change

of direction in a stock or index Support and Resistance Levels are also known in Wall Street as supply and demand And we may all know, it is supply and demand that move the market up and down Support and Resistance Levels are simply a point at which investors elect to buy and sell

an investment Although these levels can be seen visually, they are initiated

by the mind-set of investors For example, let’s assume that XYZ stock is trading at $75 After we make the purchase, it then trades down below $75 to

$67 A person’s natural reaction is to consider selling the stock when it increases back to $75 That’s what happens as many investors do the same

with stocks that trade within what is known as a trading range or trend They identify the point at which a stock tests its higher-price range ―resistance‖ and then drops down to its ―support‖ lower level

In another book ―Chart your way to profits‖, Tim Knight (2007) said that the world of technical analysis can seem overwhelming to many There are hundreds of complex mathematical indicators, studies, patterns, and rules But there is absolutely no reason good charting has to be complicated A trader can set aside all of the complexity and focus on some solid basics, starting with the ideas of support and resistance

To illustrate this, consider the children’s game Red Rover In this game, kids are divided into two groups, and each group forms a line by holding hands so that there are two parallel lines of kids standing across a field from one another Then one team calls out, ―Red Rover, Red Rover, send Ethan (or some other kid’s name) right over!,‖ and the named child rushes headlong into the other line, trying to break through If he busts through the line, he gets to choose a person to join his team

This image of ―breaking through‖ is exactly what support and resistance are all about, because in the grown-up world of trading, buyers of securities tend to mass at certain price levels And those owners will hold the line at those prices if the security tries to go above (in the case of resistance)

or below (in the case of support) Let’s take a simple, hypothetical example Suppose a given stock traded at between $4.95 and $5.05 for many months Day after day, week after week, it stayed in this range, accumulating owners

of the stock at around the $5 level Let’s go on to assume the company has

some good news, and the stock goes up to $6, but subsequent profit-taking pushes the stock back down again

Given this circumstance, you can rest assured that it’s unlikely the stock is going to drop beneath about the $5 level The reason is that there are

a huge number of owners at that level, and they are simply not going to sell Fear and greed are the primary drivers of the market, and in this case, greed

is going to come first (meaning the owners are telling the market ―I refuse to sell my stock at this price for a breakeven trade I want a profit.‖) If something remarkable happens and it shoves the stock down to, say, $4.50, the fear starts to take hold (―I am worried my losses will go even higher, so I’m going

to sell now while I still have the chance.‖), which means the selling will feed on itself

Expressed in economic terms, the stock price found equilibrium at the

$5 level, thus amassing a large number of owners If the stock price challenges that level again, equilibrium will once more take hold, stabilizing the price The people owning stock at this level constitute resistance— the

―Red Rover‖ line will hold fast, unless a very powerful force punches through

it

Support, therefore, is a price level at which prices are prone to stay above Resistance is a price level at which prices are prone to stay below So these are reliable levels at which to count on a pause in price movement, unless the levels are violated, which is where the real action is

What Happens When Prices Punch Through?

The time when profits are made is when prices push through support or resistance and break out The longer a price has been trying to push through

a certain price level, the more forceful it will be when it finally does make it through (think back to our Red Rover game, and picture a particularly eager youngster who has tried ten times to get through the line and is more determined than ever to do so)

The author used ALVR as an example of how potent this is The first half of the stock chart for ALVR shows prices bouncing between about $2.00 and $2.50 For month after month the stock was completely stagnant, and buyers were accumulating at these levels There were several attempts to push through resistance (represented by the horizontal line), but they failed until the midpoint of the graph, in April

Figure 11 ALVR breaking out of resistance

(After breaking out of a saucer pattern, ALVR blasted ahead on much bigger volume

to a 500% gain in about a year.)

At that point, three important things happened: (1) buyers overcame sellers, pushing prices above resistance; (2) volume increased as excitement began to build around the stock; and (3) when some profit-taking took place, prices eased back, but they did not go beneath the former line of resistance From that point, the stock moved up to 500% in the course of a year

The concept of how resistance can change into support (and vice versa) is critical to your understanding of reading a chart Any sort of line—be

it a trend line, a channel, a horizontal line—has two faces to it: support and resistance Once prices cross a line, the nature of that line will be changed

The author used the example of stock for Chesapeake Energy (symbol CHK) over a period of about half a year to see how valuable it is to have an awareness of price behavior at certain levels Early on, the price was blasting skyward to a new high, then it slumped down through August It then regained its footing and mounted a new assault on higher prices, but it was repelled again at about the same level A couple of months later, in November, a third attempt was made to push past the $34 barrier, but it failed on the third time

We can imagine the frustration and exasperation of the owners of this stock

as they kept seeing their stock getting shoved away from higher prices

What the market was telling the owners of this stock was: ―You’re not going to go any higher.‖ The supply of stock (those selling it) was creating what is known as overhead resistance Perhaps some people who bought earlier at $34 promised themselves that the moment the stock recovered to a break-even level, they would get out Perhaps most people felt the stock was fully valued at $34 The reasons really don’t matter; the fact is that over a six-

month period, there was an invisible line drawn on the stock chart through which prices simply could not pass

Figure 12 Resistance Failed

Figure 12 Resistance Failed (This is known as a triple top, where a new

high happens three times, but the price can’t get above it Once the attempts

at overcoming this resistance failed, the stock collapsed.)

Figure 13 Price Shrunken after Triple Top

(After its triple top, CHK went on to a nearly 99% decline in price.)

What happened afterwards is very interesting: far from pushing above the $34 price, the stock instead started collapsing As above Figure shows, CHK withered away from $34 per share to about 50 cents, almost a 99% decline Clearly the stock had worse problems than a triple top, but the important point here is that the market was telling the owners of the stock something, and the triple top was a warning that this was a stock to sell, not keep

Moving Averages

In the publication ―Charting Made Easy‖, John J Murphy (2000) stated that in the realm of technical indicators, moving averages are extremely popular with market technicians and with good reason Moving averages smooth the price action and make it easier to spot the underlying trends Precise trend signals can be obtained from the interaction between a price and an average or between two or more averages themselves Since the moving average is constructed by averaging several days’ closing prices, however, it tends to lag behind the price action The shorter the average (meaning the fewer days used in its calculation), the more sensitive it is to price changes and the closer it trails the price action A longer average (with more days included in its calculation) tracks the price action from a greater distance and is less responsive to trend changes The moving average is easily quantified and lends itself especially well to historical testing Mainly for those reasons, it is the mainstay of most mechanical trend-following systems

Popular Moving Averages

In stock market analysis, the most popular moving average lengths are

50 and 200 days [On weekly charts, those daily values are converted into 10 and 40-week averages.] During an uptrend, prices should stay above the 50-day average Minor pullbacks often bounce off that average, which acts as a support level A decisive close beneath the 50-day average is usually one of the first signs that a stock is entering a more severe correction In many cases, the breaking of the 50-day average signals a further decline down to the 200-day average If a market is in a normal bull market correction, it should find new support around its 200-day average [For short-term trading purposes, traders will employ a 20-day average to spot short-term trend changes]

Bollinger Bands

These are trading bands plotted two standard deviations above and below a 20-day moving average When a market touches (or exceeds) one of the trading bands, the market is considered to be over-extended Prices will often pull back to the moving average line

Moving Average Convergence Divergence (MACD)

The MACD is a popular trading system On your computer screen, you’ll see two weighted moving averages (weighted moving averages give greater weight to the more recent price action) Trading signals are given when the two lines cross

Relative Strength Index (RSI)

In the book, ―Technical Analysis for the Trading Professional - Irwin Trader's Edge Series‖, Brown and Constance M (1999) believed that the Relative Strength Index is more than a momentum oscillator from which market ―overbought‖ and ―oversold‖ conditions can be identified This indicator has the ability to forecast future market levels from specific indicator patterns called Positive and Negative Reversals The price projection characteristics of the RSI were not discovered by J Welles Wilder, who first developed the RSI formula, but by Andrew Cardwell who is recognized by many to be the world's leading authority on the Relative Strength Index It is because of Cardwell's focused research on a single indicator that we now have this method of price forecasting What is of particular interest is that the signals Cardwell first identified within the RSI formula are present in other oscillators His work with the RSI has actually opened the door to a new method of using oscillators in general for price projection

While Cardwell has been giving lectures around the world since 1989

to select audiences about his price projection techniques derived from the RSI, he is not widely known, and his methods have not been formally published His lectures are similar to the writings of W D Gann There is so much detail in his lectures and charts that it is easy to get lost in the volume of information he extracts from every single RSI squiggle As the author believes

no method should be used in isolation, his intention is to focus on the polished gem within his methodology: his approach of calculating new price objectives for a market

The three methods the author uses for obtaining a price objective for a market are Gann, Fibonacci, and Andrew Cardwell's Reversal signals derived from the RSI Cardwell's methods are perhaps the least known, and the author will attempt to correct that oversight now as he has made a major contribution to the field of technical analysis

Figure 14 Use of RSI

The author demonstrates the use of Relative Strength Index with a daily bar chart of Yen futures In the above figure, the standard default period

of 14 is used for the Relative Strength Index The Yen is falling in a bear market within this time horizon The graph showing the RSI indicator has an upper black band marking a range of resistance from 60 to 65 A lower band marks 23 to 28 to highlight a support zone for the indicator If we study the indicator tops closely, we can see that at no time is the Yen strong enough to push the RSI oscillator successfully through the 65 level (Spot traders need

to keep in mind that this is a futures chart, which will be inverted from the spot

market.) Each time the indicator tests the range from 55 to 65; the Yen renews its former downtrend and establishes new lows against the dollar The oscillator then declines to a support zone within a range of 20 to 30 There will

be many more examples to reinforce this concept The general rule to follow for a bear market is that RSI will oscillate within a range of 20 to 30 at the low end of the scale up to an upper resistance zone of 55 to 65 This is true regardless of market or time horizon

In a bull market the RSI will shift and begin to oscillate within a range marked by a support zone of 40 to 50 toward an upper resistance zone of 80

to 90 The below figure shows the same Yen futures market but over a weekly time horizon when the Yen is in a bull market or the dollar is weak Each time the Yen declines, the oscillator falls to a support zone near 40 to 50 The 40 level is never broken The strong Yen rallies push the oscillator into the 80s Even minor advances that lead to more complex consolidations allow the RSI

to decline only as far back as the 40 to 50 zone

Figure 15 Range of RSI Working as Support

The author believes RSI ranges defining bull and bear markets apply to other oscillators The signal will warn the trader that the market could target

an additional move equal to the rally that preceded the minor pullback that allowed the indicator to decline from its extreme high over 80

Bollinger Bands

In the book, ―Trend trading: timing market tides‖, Kedrick F Brown (2006) describes how the famous technical analyst, John Bollinger, developed what have become known as Bollinger bands We may construct Bollinger bands for trading purposes as follows (excluding today’s prices from our calculations)

• Upper Bollinger band: The moving average of the past N periods (not including the current period) PLUS twice the standard deviation of the past N closing prices (not including the closing price of the current period)

• Lower Bollinger band: The moving average of the past N periods (not including the current period) MINUS twice the standard deviation of the past N closing prices (not including the closing price of the current period)

The distance between Bollinger bands expands and contracts based

on the standard deviation of prices over the period being used Although Bollinger bands may be used to time trades in a similar manner to Donchian bands (i.e., buying breakouts and selling breakdowns), some issues may arise if doing this For example, let’s say that you use the trading rules:

1 Buy when price makes an intraday breakout (by one tick) above the upper Bollinger band

2 Hold position and sell when price makes an intraday breakdown (by one tick) below the lower Bollinger band

3 Repeat

Figure 16 Lower Donchian Bands Cannot Drop Before Price Falls Through

Them

(Source: © TradeStation® 1991–2006 All rights reserved.)

Although this method may make sense in some cases, Bollinger bands sometimes exhibit a characteristic that Donchian bands do not Namely, the author believes a lower Donchian band will never drop unless price breaks below it first, as shown in the above figure, and an upper Donchian band will never rise unless price breaks above it first The lower Bollinger band, on the other hand, may sometimes drop even when price has not broken down through it first, as shown in the below figure

This means that if traders want to use the lower Bollinger band as a trailing stop level, they may sometimes find themselves in the unusual