Tools in Forex Market: Trend Lines
Tools in Forex Market: Trend Lines
Trend Lines
Technical analysis is built on the assumption that prices trend. Trend Lines are an important tool
in technical analysis for both trend identification and confirmation. A trend line is a straight line
that connects two or more price points and then extends into the future to act as a line of support
or resistance. Many of the principles applicable to support and resistance levels can be applied to
trend lines as well. It is important that you understand all of the concepts presented in
our Support and Resistance articlebefore you continue.
Definition
Uptrend Line
An uptrend line has a positive slope and is formed by connecting two or more low points. The
second low must be higher than the first for the line to have a positive slope. Uptrend lines act as
support and indicate that net-demand (demand less supply) is increasing even as the price rises.
A rising price combined with increasing demand is very bullish, and shows a strong
determination on the part of the buyers. As long as prices remain above the trend line, the
uptrend is considered solid and intact. A break below the uptrend line indicates that net-demand
has weakened and a change in trend could be imminent.
Downtrend Line
A downtrend line has a negative slope and is formed by connecting two or more high points. The
second high must be lower than the first for the line to have a negative slope. Downtrend lines
act as resistance, and indicate that net-supply (supply less demand) is increasing even as the price
declines. A declining price combined with increasing supply is very bearish, and shows the
strong resolve of the sellers. As long as prices remain below the downtrend line, the downtrend is
solid and intact. A break above the downtrend line indicates that net-supply is decreasing and
that a change of trend could be imminent.
For a detailed explanation of trend changes, which are different than just trend line breaks, please
see our article on the Dow Theory.
Scale Settings
High points and low points appear to line up better for trend lines when prices are displayed
using a semi-log scale. This is especially true when long-term trend lines are being drawn or
when there is a large change in price. Most charting programs allow users to set the scale as
arithmetic or semi-log. An arithmetic scale displays incremental values (5, 10,15,20,25,30)
evenly as they move up the y-axis. A $10 movement in price will look the same from $10 to $20
or from $100 to $110. A semi-log scale displays incremental values in percentage terms as they
move up the y-axis. A move from $10 to $20 is a 100% gain, and would appear to be a much
larger than a move from $100 to $110, which is only a 10% gain.
In the case of EMC , there was a large price change over a long period of time. While there
were not any false breaks below the uptrend line on the arithmetic scale, the rate of ascent
appears smoother on the semi-log scale. EMC doubled three times in less than two years. On the
semi-log scale, the trend line fits all the way up. On the arithmetic scale, three different trend
lines were required to keep pace with the advance.
There were two false breaks above the downtrend line as the stock declined during 2000 and
2001. These false break outs could have led to premature buying as the stock continued to
decline after each one. The stock lost 60% of its value three times over a two year period. The
semi-log scale reflects the percentage loss evenly, and the downtrend line was never broken.
Validation
It takes two or more points to draw a trend line The more points used to draw the trend line, the
more validity attached to the support or resistance level represented by the trend line. It can
sometimes be difficult to find more than 2 points from which to construct a trend line Even
though trend lines are an important aspect of technical analysis, it is not always possible to draw
trend lines on every price chart. Sometimes the lows or highs just don't match up, and it is best
not to force the issue. The general rule in technical analysis is that it takes two points to draw a
trend line and the third point confirms the validity.
The chart of Microsoft (MSFT) shows an uptrend line that has been touched 4 times. After the
third touch in Nov-99, the trend line was considered a valid line of support. Now that the stock
has bounced off of this level a fourth time, the soundness of the support level is enhanced even
more. As long as the stock remains above the trend line (support), the trend will remain in
control of the bulls. A break below would signal that net-supply was increasing and that a change
in trend could be imminent.
Spacing of Points
The lows used to form an uptrend line and the highs used to form a downtrend line should not be
too far apart, or too close together. The most suitable distance apart will depend on the time
frame, the degree of price movement, and personal preferences. If the lows (highs) are too close
together, the validity of the reaction low (high) may be in question. If the lows are too far apart,
the relationship between the two points could be suspect. An ideal trend line is made up of
relatively evenly spaced lows (or highs). The trend line in the above MSFT example represents
well-spaced low points.
On the Wal-Mart (WMT) example, the second high point appears to be too close to the first high
point for a valid trend line; however, it would be feasible to draw a trend line beginning at point
2 and extending down to the February reaction high.
Angles
As the steepness of a trend line increases, the validity of the support or resistance level decreases.
A steep trend line results from a sharp advance (or decline) over a brief period of time. The angle
of a trend line created from such sharp moves is unlikely to offer a meaningful support or
resistance level. Even if the trend line is formed with three seemingly valid points, attempting to
play a trend line break or to use the support and resistance level established it will often prove
difficult.
The trend line for Yahoo! (YHOO) was touched four times over a 5-month period. The spacing
between the points appears OK, but the steepness of the trend line is unsustainable, and the price
is more likely than not to drop below the trend line. However, trying to time this drop or make a
play after the trend line is broken is a difficult task. The amount of data displayed and the size of
the chart can also affect the angle of a trend line. Short and wide charts are less likely to have
steep trend lines than long and narrow charts. Keep that in mind when assessing the validity and
sustainability of a trend line.
Sometimes there appears to be the possibility for drawing a trend line, but the exact points do not
match up cleanly. The highs or lows might be out of whack, the angle might be too steep or the
points might be too close together. If one or two points could be ignored, then a fitted trend line
could be formed. With the volatility present in the market, prices can over-react, and produce
spikes that distort the highs and lows. One method for dealing with over-reactions is to draw
internal trend lines. Even though an internal trend line ignores price spikes, the ignoring should
be within reason.
The long-term trend line for the S&P 500 ($SPX) extends up from the end of 1994, and passes
through low points in Jul-96, Sept-98 and Oct-98. These lows were formed with selling
climaxes, and represented extreme price movements that protrude beneath the trend line. By
drawing the trend line through the lows, the line appears to be at a reasonable angle, and the
other lows match up extremely well.
Sometimes, there is a price cluster with a high or low spike sticking out. A price cluster is an
area where prices are grouped within a tight range over a period of time. The price cluster can be
used to draw the trend line, and the spike can be ignored. The Coca Cola (KO) chart shows an
internal trend line that is formed by ignoring price spikes and using the price clusters, instead. In
October and November 1998, Coke formed a peak, with the November peak just higher than the
October peak (1). If the November peak had been used to draw a trend line, then the slope would
have been more negative, and there would have appeared to be a breakout in Dec-98 (gray line).
However, this would have only been a two-point trend line, because the May-June highs are too
close together (black arrows). Once the Dec-99 peak formed (green arrow), it would have been
possible to draw an internal trend line based on the price clusters around the Oct/Nov-98 and the
Dec-99 peaks (blue line). This trend line is based on three solid touches, and it accurately
forecasts resistance in Jan-00 (blue arrow).
Conclusion
Trend lines can offer great insight, but if used improperly, they can also produce false signals.
Other items - such as horizontal support and resistance levels or peak-and-trough analysis -
should be employed to validate trend line breaks. While trend lines have become a very popular
aspect of technical analysis, they are merely one tool for establishing, analyzing, and confirming
a trend. Trend lines should not be the final arbiter, but should serve merely as a warning that a
change in trend may be imminent. By using trend line breaks for warnings, investors and traders
can pay closer attention to other confirming signals for a potential change in trend.
The uptrend line for VeriSign (VRSN) was touched 4 times, and seemed to be a valid support
level. Even though the trend line was broken in Jan-00, the previous reaction low held, and did
not confirm the trend line break. In addition, the stock recorded a new higher high prior to the
trend line break.
Equidistant Channel
Equidistant Channel represents two parallel trend lines connecting extreme maximum and
minimum close prices. Market price jumps, draws peaks and troughs forming the channel in the
trend direction. Early identification of the channel can give a valuable information including that
about changes in the trend direction what allows to estimate possible profits and losses. It is
necessary to give the direction of the channel and its width to build the instrument.
Standard Deviation Channel consists of two parallel lines, equidistant up and down from the
Linear Regression Trend. The distance between frame of the channel and regression line equals
to the value of standard close price deviation from the regression line. All price changes take
place within Standard Deviation Channel, where the lower frame works as support line, and the
upper one does as resistance line. Prices usually exceed the channel frames for a short time. If
they keep outside of the channel frames for a longer time than usually, it forecasts the possibility
of trend turn.
Raff or Linear Regression Channel
Linear Regression Channel is built on base of Linear Regression Trend representing a
usual trendline drawn between two points on a price chart using the method of least squares. As a
result, this line proves to be the exact median line of the changing price. It can be considered as
an equilibrium price line and any deflection up or down indicates the super activity of buyers or
sellers.
Linear Regression Channel consists of two parallel lines, equidistant up and down from the line
of linear regression trend. The distance between frame of the channel and regression line equals
to the value of maximum close price deviation from the regression line. All price changes take
place within Regression Channel, where the lower frame works as support line, and the upper
one does as resistance line. Prices usually exceed the channel frames for a short time. If they
keep outside of the channel frames for a longer time than usually, it forecasts the possibility
of trend turn.
Introduction
Developed by Gilbert Raff, the Raff Regression Channel is a linear regression with evenly
spaced trendlines above and below. The width of the channel is based on the high or low that is
the furthest from the linear regression. The trend is up as long as prices rise within this channel.
An uptrend reverses when price breaks below the channel extension. The trend is down as long
as prices decline within the channel. Similarly, a downtrend reverses when price breaks above
the channel extension.
Formula
The Raff Regression Channel is based on a linear regression, which is the least-squares line-of-
best-fit for a price series. Even though the formula is beyond the scope of this article, linear
regressions are easy to understand with a visual example. Chart 1 shows the Nasdaq 100 ETF
(QQQQ) with the Raff Regression Channel in red. The middle line is the linear regression
extending from the July closing low to the January closing high. Note that the linear regression is
based on closing prices. This makes the linear regression the line-of-best-fit for the closing prices
from the July low to the January high. Next, the width is set by determining the high or low that
is the furthest from the linear regression (from early July to mid January). The low immediately
after the start is the furthest and it is used to set the distance for the trendlines. The upper
trendline is then set the same distance from the linear regression as the lower trendline.
Chart 2 shows an example of QQQQ in a downtrend. The Raff Regression Channel extends from
the April (closing) high to the July (closing) low. The early July high defines the width of the
channel because it is the furthest high or low from the linear regression. This means the lower
trendline is set the same distance from the linear regression as the upper trendline.
Drawing and Signals
The Raff Regression Channel can be drawn to cover the existing trend and subsequently define
the trend. Once established, extension lines can be drawn to identify the reversal point. An
uptrend extends from the lowest reaction low to the highest reaction high for a move. A
downtrend extends from the highest reaction high to the lowest reaction low. Keep in mind that
closing prices are used when drawing the Raff Regression Channel, but intraday highs and lows
are used to set the equidistant trendlines.
Chart 3 shows Urban Outfitters (URBN) with the Raff Regression Channel drawn from the July
2007 low to the September 2008 high (weekly closes). This covers the uptrend so far. Had
URBN moved to a new reaction high in October, the Raff Regression Channel would have
extended to that high. Instead of moving to a new high, URBN broke below the regression
channel extension to reverse the uptrend. Notice that the lower trendline was extended to
extrapolate the channel.
Chart 4 shows Nvidia (NVDA) with a downtrend extending from the October 2007 high to the
November 2008 low. The Raff Regression Channel did not extend further because the stock
traded flat and held above its November low into 2009. The red dotted line shows the channel
extension or the regression channel top. NVDA broke this extension in February-March to start
an uptrend.
Conclusions
As a channel based on a linear regression, the Raff Regression Channel is well suited for trend
identification. The width of the channel depends on the furthest high or low from the linear
regression. As such, spike highs and lows will result in very wide channels that may not capture
the true range. When an uptrend starts with a sharp surge, the low a few days after this initial
surge is often the furthest high-low from the linear regression. By extension, when a downtrend
starts with a sharp decline, the high of this initial decline often the furthest high-low from the
linear regression. Sharp initial moves create wide channels with few, if any, reaction highs or
lows touching the upper and lower trendlines. Such was the case with the surge off the March
2009 lows (see the QQQQ chart further below). Even though this article only focused on trend
identification, the Raff Regression Channel can be drawn early in the trend and extended to
forecast future support or resistance levels as well as overbought or oversold levels. Channel
extensions can act as support or resistance. Moves outside the channel extensions can also denote
overbought or oversold conditions.
The Raff Regression Channel tool can be found when annotating a SharpChart. The icon is a
gray zigzag with a green line through it. Left click on the icon to select it. Left click on the
starting point and drag the indicator to the ending point. To rearrange an existing Raff
Regression Channel, click on the start or end of the linear regression (middle line) and move
accordingly. Extensions can be added manually using the trendline tool in SharpCharts.
Andrews' Pitchfork
Introduction
Developed by Alan Andrews, Andrews' Pitchfork is a trend channel tool consisting of three
lines. There is a median trendline in the center with two parallel equidistant trendlines on either
side. These lines are drawn by selecting three points, usually based on reaction highs or lows
moving from left to right on the chart. As with normal trendlines and channels, the outside
trendlines mark potential support and resistance areas. A trend remains in place as long as the
Pitchfork channel holds. Reversals occur when prices break out of a Pitchfork channel.
The first step to using Andrews Pitchfork is selecting three points for drawing. These points are
usually based on reaction highs or reaction lows, also referred to as pivot points. Chart 1 shows
McKesson (MCK) with Andrews' Pitchfork extending up from the June low. The first point
selected marks the start of the median line. Points 2 and 3 define the width of the Pitchfork
channel. The median line is based on two points: point one and the midpoint between points 2
and 3. As such, the median line starts a point 1 and bisects points 2 and 3. This controls the slope
(steepness) of the median line. The outside trendlines are then extended parallel to the median
line. The red Andrews' Pitchfork shows an alternative median line based on the July low for
point 1. Notice that the red median line still bisects the line between points 2 and 3, but it is
steeper than the blue median line. Pitchfork slope depends on the placement of point 1.
Chart 2 shows a downward sloping Andrews' Pitchfork with Accenture (ACN). The blue median
line starts at point 1 and bisects the line between points 2 and 3. The outside trendlines are
parallel and equidistant from the median line. For slope reference, the red Pitchfork uses the
August low as point 1, which makes the median line steeper.
Flexibility with Point 1
Sometimes the median line needs adjusting to establish a realistic slope. Pitchforks that are too
steep will be easily broken. Pitchforks that are too flat will not capture the trend. Chart 3 shows
Electronic Arts (ERTS) with Andrews' Pitchfork extending up from the late January low. Ideally,
point 1 would be based on the low for the move. Points 2 and 3 would mark the first reaction
high and reaction low after the first low. However, a median line based on the late January low
offers support in March and resistance in July. More importantly, it creates a channel that
contains price action for many months. Notice that ERTS became overbought when prices
moved above the upper trendline of the Pitchfork. The trend fully reversed with the break below
the lower trendline.
Chart 4 shows Intuit (INTU) with two possible Pitchforks. The red Pitchfork was too steep.
Notice that the trend did not reverse when prices moved below the lower trendline in late April.
The alternative was to base the median line on the mid December low. This creates a flatter
Pitchfork that is more realistic for an uptrend. As with normal trendlines, steep trendlines are
more easily broken. The validity of the blue Pitchfork was confirmed when prices hit resistance
at the upper trendline in early April and found support at the lower trendline in early May.
Support, Resistance & Reversal
Pitchfork trendlines can provide support or resistance. In an uptrend, the lower trendline acts as
support to define the overall trend, the upper trendline acts as resistance and the median line
defines the strength of the trendline. Prices should reach the median line on a regular basis
during an uptrend. Failure to reach this line shows underlying weakness that could foreshadow a
trend reversal. Chart 5 shows Ciena (CIEN) moving higher within a rising Pitchfork. Notice how
the lower trendline offers support and the median line offers resistance. Even though Ciena met
resistance at the median line throughout the uptrend, it managed to reach this line on a regular
basis to affirm the uptrend. Failure to reach the median line would have shown underlying
weakness. CIEN broke the lower trendline with a sharp decline in November. Notice that this
break held as the trendline then turned into resistance.
Chart 6 shows CSX Corp (CSX) with a pair of corrections identified by Andrews' Pitchfork.
Notice that both corrections formed after sharp advances. For the first correction, it was possible
to draw Andrews' Pitchfork after the early July high. Notice that prices did not break the median
line in late July. Also notice that prices held above the median line in August. This showed
strength that led to a breakout in September. It was possible to draw the second correction after
the early December high. Prices did move below the median line, but soon recovered and CSX
broke resistance with a surge in January.
Trigger Lines
Andrews Pitchfork also incorporates the use of trigger lines. The upper trigger line is based on
points 1 and 2. The lower trigger line is based on points 1 and 3. These lines are used for buy and
sell signals. In a downtrend, a break above the upper trigger line triggers a buy signal. In an
uptrend, a break below the lower trigger line acts as a sell signal. Trigger lines have been added
to the CSX and CIEN charts above. These trigger lines are usually the same as normal trendlines
drawn off two reaction highs or reaction lows. As such, their signals are often much later than
the signals generated by Pitchfork breaks.
Conclusions
The steepness of the Pitchfork channel depends on the placement of the three drawing points, in
particular point 1, which is the start of the median line. Even though point one usually starts with
a reaction high or low, it is sometimes necessary to adjust point 1 to insure a realistic price
channel. Unfortunately, there are no hard rules for point placement. Instead, chartists must use
judgment and experience when drawing channels. This is where the subjective part of technical
analysis comes into play. As with most aspects of technical analysis, it is important to build
experience by experimenting with Andrews' Pitchfork. See what works and what doesn't work
first hand. This is the only real way to master an indicator.
The Andrews Pitchfork tool can be accessed when annotating a SharpChart. There are four steps
involved. First, click on the Andrews Pitchfork tool icon at the top. Second, move the cursor to
the chosen starting point for the median line. Left click to set point 1. Third, move to the second
point and left click to set point 2. Fourth, move to the third point and left click to set point 3.
Andrews' Pitchfork will now appear on the chart with the median line and outer trendlines
extended.
Gann instruments
Gann line
Gann Line represents a line drawn at the angle of 45 degrees. This line is also called "one to one"
(1x1) what means one change of the price within one unit of time.
According to Gann’s concept, the line having the slope of forty-five degrees represents a long-
term trendline (ascending or descending). While prices are above the ascending line, the market
holds bull directions. If prices hold below the descending line, the market is characterized as a
bear one. Intersection of Gann Line usually signals of the basic trend break. When prices go
down to this line during an ascending trend, time and price become fully balanced. The further
intersection of Gann Line is the evidence of breaking of this balance and possible changing
the trend .
Gann Fan
Lines of Gann Fan are built at different angles from an important base or peak at the price chart.
The trend line of 1х1 was considered by Gann the most important. If the price curve is located
above this line, it is the indication of the bull market, if it is below this line it is that of the bear
market. Gann thought that the ray of 1x1 is a powerful support line when the trend is ascending,
and he considered the breaking this line as an important turn signal. Gann emphasized the
following nine basic angles, the angle of 1x1 being the most important of all:
Gann noted that each of the above-listed rays can serve as support or resistance depending on the
price trend direction. For example, ray of 1x1 is usually the most important support line when the
trend is ascending. If prices fall below 1х1 line, it means the trend turns. According to Gann,
prices should then sink down to the next trend line (in this case, it is the ray of 2х1). In other
words, if one of rays is broken, the price consolidation should be expected to occur near the next
ray.
Gann Grid
Gann Grid represents trends built at the angle of 45 degrees (Gann Lines). According to Gann’s
concepts, a line having a slope of forty-five degrees represents a long-term trendline (ascending
or descending). While prices are above the ascending line, the market holds bull direction. If
prices hold below descending line, the market is characterized as a bear one. Intersection of the a
xhref="/gann_line">Gann Line usually signals of breaking the basic trend. When prices go down
to this line during an ascending trend, time and price become fully balanced. The further
intersection of Gann Lines is an evidence of breaking of this balance and possible change of the
trend.
To build a Gann Grid, it is necessary to define two points determining sizes of cells.
Cycles
Introduction
A cycle is an event, such as a price high or low, which repeats itself on a regular basis. Cycles
exist in the economy, nature and the financial markets. The basic business cycle encompasses an
economic downturn, bottom, economic upturn and top. Cycles in nature include the four seasons
and solar activity (11 years). Cycles are also part of technical analysis in the financial markets.
Cycle theory asserts that cyclical forces, both long and short, drive price movement in the
financial markets.
Price and time cycles are used to anticipate turning points. Lows are normally used to define
cycle length and then project future cycle lows. Even though there is evidence that cycles do
indeed exist, cycles change over time and even disappear at times. While this may sound
discouraging, trend is the same way. There is indeed evidence that markets trend. but not all the
time. Trend disappears when markets move into a trading range or even reverses. Cycles can also
disappear and even invert. Do not expect cycle analysis to pinpoint reaction highs or lows.
Instead, cycle analysis should be used in conjunction with other aspects of technical analysis to
anticipate turning points.
The image below shows a perfect cycle with a length of 100 days. Not all cycles are this well-
defined. This is just a blueprint for the ideal cycle. The first peak is at 25 days and the second
peak is at 125 days (125 - 25 = 100). The first cycle low is at 75 and the second cycle low is at
175, 100 days later. Also notice that the cycle crosses the Y axis at 50, 100 and 150, which is
every 50 points or half a cycle.
Crest: Cycle high
Trough: Cycle low
Phase: Position of cycle on particular point in time. This cycle is at .95 on day 20.
Inflection Point: This is where the cycle line crosses the Y axis.
Amplitude: Height of the cycle from Y axis to peak or trough.
Length: Distance between cycle highs or cycle lows
Cycle Characteristics
Cycle Length: Lows are usually used to define the length of a cycle and project the cycle into the
future. A cycle high can be expected somewhere between the cycle lows.
Translation: Cycles almost never peak at the exact midpoint or trough at the expected cycle low.
Most often, peaks occur before or after the midpoint of the cycle. Right translation is the
tendency of prices to peak in the latter part of the cycle during bull markets. Conversely, left
translation is the tendency of prices to peak in the front half of the cycle during bear markets.
Prices tend to peak later in bull markets and earlier in bear markets.
Harmonics: Larger cycles can be broken down into smaller, and equal, cycles. A 40 week cycle
divides into two 20-week cycles. A 20-week cycle divides into two 10 week cycles. Sometimes a
larger cycle can divide into three or more parts. The inverse is also true. Small cycles can
multiply into larger cycles. A 10-week cycle can be part of a larger 20-week cycle and an even
larger 40-week cycle.
Nesting: A cycle low is reinforced when several cycles signal a trough at the same time. The 10-
week, 20-week and 40-week cycles are nesting when they all trough at the same time.
Inversions: Sometimes a cycle high occurs when there should be a cycle low and visa versa. This
can happen when a cycle high or low is skipped or is minimal. A cycle low may be short or
almost non-existent in a strong uptrend. Similarly, markets can fall fast and skip a cycle high
during sharp declines. Inversions are more prominent with shorter cycles and less common with
longer cycles. For instant, one could expect more inversions with a 10-week cycle than a 40-
week cycle. ycl
Data Categories
The data points on a price chart can be split into three categories: trending, cyclical or random.
Trending data points are part of a sustained directional move, usually up or down. Cyclical data
points are recurring diversions from the mean. Diversions occur when prices move above or
below the mean. Random data points are noise, usually caused by intraday or daily volatility.
Cycles can be found by removing trend and random noise from the price data. Random data
points can be removed by smoothing the data with a moving average. The trend can be isolated
by de-trending the data. This can be done by focusing on movements above and below a moving
average. Alternatively, the Detrended Price Oscillator can be used (see below).
Steps to Find Cycles
1. Set chart to log scale (this can be found under "chart attributes")
When looking for cycles, it is important to view price changes in percentage terms instead of
absolute terms. On an arithmetic scale, an advance from 100 to 200 will look the same as an
advance from 300 to 400. Even though both advances are 100 points, they are much different in
percentage terms. A move from 100 to 200 is +100%, while a move from 300 to 400 is +33.3%.
On a log scale, the move from 100 to 200 will appear much larger than the move from 300 to
400. This is because the percentage change from 100 to 200 is much bigger than the percentage
change from 300 to 400. A log scale chart is needed to properly compare price action across a
specific timeframe, especially with a long timeframe stretching over two years.
2. Smooth the price series with a short simple moving average. This is to eliminate the random
noise and focus on the general movements. A short 5-day SMA is often adequate. Smoothing
also helps to define reaction lows when volatility is high, such as October-November 2008.
3. Visually analyze the charts for possible cycle lows. This is perhaps the easiest way to find
cycles. Find a few lows that appear to have the same cycle length and extend that cycle into the
future.
4. Detrend the price series to focus on cycle lows. Detrending can be done with the Detrended
Price Oscillator (DPO). This indicator is based on a centered moving average. In other words, a
moving average that has been displaced to the left by a factor (N/2 + 1). A 20-day DPO would be
based on a 20-day moving average displaced to the left (back) by 11 days [(20/2 + 1) = 11)].
DPO would then be the closing price less the value of the displaced moving average. The
resulting oscillator reflects price movements above and below this displaced moving average.
We can then use oscillator dips to identify a cycle. Notice that the DPO ends before the last
price. This is because the moving average is displaced and the DPO aligns with the displaced
moving average. It often helps to set the DPO in line with the cycle length. Use a 10-period DPO
when looking for 10-day cycle lows or a 40-day DPO when looking for 40-day cycle lows. The
chart below shows the S&P 500 with the Detrended Price Oscillator and Cycle Lines Tool. The
chart is shown in log scale to view the movements as percentages. SPX is shown as a 5-day
SMA that is displaced 3 days. This puts the plot in the middle of the moving average period.
Visual analysis suggests that there is a three month cycle at work. Therefore, the Detrended Price
Oscillator is set at 65 days to confirm the suspected cycle. The Detrended Price Oscillator turns
negative every few months confirm a recurring cycle at work. The blue arrows show the initial
estimates for the 65-day cycle. The Cycle Lines Tool is then applied to evenly spread the cycles
and project into the future.
Calendar Cycles
As its name suggests, the Presidential Cycle is based on the first and second half of the
President's term. This cycle is not infallible, but it has produced good results over the last 50
years. Stocks tend to rise in general, but the S&P 500 rose more during the second half of the
President's term than the first half. The chart below shows the S&P 500 with the Presidential
Cycle over the last 20 years. It starts with Reagan's first two years (1981-1982) and ends with
Obama's first year (2009).
Yale Hirsch, founder of the Stock Trader's Almanac. discovered the six month cycle in 1986.
This cycle is one of the more popular on Wall Street. The bullish period extends from November
to April and the bearish period extends from May to October. "Go away and sell in May" comes
from this cycle. Sy Harding took the Six-Month and Presidential Cycles further by adding
MACD for timing. Basically, buy when both cycles are bullish and MACD turns positive. Sell
when both cycles are bearish and MACD turns negative. This is a great example of using other
indicators in conjunction with cycles to improve performance.
Conclusions
Once identified and understood, cycles can add significant value to the technical analysis tool
box. Cycles are not perfect though. Some will miss, some will disappear and some will provide a
direct hit. This is why it is important to use cycles in conjunction with other aspects of technical
analysis. Trend establishes direction, oscillators define momentum and cycles anticipate turning
points. Look for confirmation with support or resistance on the price chart or a turn in a key
momentum oscillator. It can also help to combine cycles. For example, the stock market is
known to have 10-week, 20-week and 40-week cycles. These cycles can be combined with the
Six Month Cycle and Presidential Cycle for added value. Signals are enhanced when multiple
cycles nest at a cycle low.
The Cycle Lines Tool can be accessed when annotating a Sharp Chart. There are two steps
involved. First, click on the Cycle Lines Tool icon at the top. It is the icon with the horizontal
green lines. Second, move the cursor to the first cycle low, click and hold the left mouse button
and then drag to the right the desired cycle length. It is sometimes helpful to measure the first
two cycle lows with vertical lines. For a 20 day cycle, place a vertical line on the first low, count
20 days and then place a second vertical line. Start the Cycle Lines Tool from the first cycle low
and extend it to the second cycle low for the first 20-day cycle. The subsequent cycles will also
be 20-days.
The snapshot below comes from the SharpCharts settings for cycle analysis. First, a price plot
can be made "invisible" under Chart Attribute/Type. Second, the Log Scale box can be selected
to view price moves as percentage changes. Third, it is sometimes necessary to add extra bars to
the chart to extend cycle lines into the future. Fourth, a displaced 5-day SMA was used as an
overlay. Fifth, the Detrended Price Oscillator is set at 20 days and shown in the indicator window
below.
FIBONACCI
Fibonacci Retracements
Introduction
Fibonacci Retracements are ratios used to identify potential reversal levels. These ratios are
found in the Fibonacci sequence. The most popular Fibonacci Retracements are 61.8% and
38.2%. Note that 38.2% is often rounded to 38% and 61.8 is rounded to 62%. After an advance,
chartists apply Fibonacci ratios to define retracement levels and forecast the extent of a
correction or pullback. Fibonacci Retracements can also be applied after a decline to forecast the
length of a counter trend bounce. These retracements can be combined with other indicators
and price patterns to create an overall strategy.
This article is not designed to delve too deep into the mathematical properties behind the
Fibonacci sequence and Golden Ratio. There are plenty of other sources for this detail. A few
basics, however, will provide the necessary background for the most popular numbers. Leonardo
Pisano Bogollo (1170-1250), an Italian mathematician from Pisa, is credited with introducing the
Fibonacci sequence to the West. It is as follows:
The sequence extends to infinity and contains many unique mathematical properties.
After 0 and 1, each number is the sum of the two prior numbers (1+2=3, 2+3=5, 5+8=13
8+13=21 etc…).
A number divided by the previous number approximates 1.618 (21/13=1.6153,
34/21=1.6190, 55/34=1.6176, 89/55=1.6181). The approximation nears 1.6180 as the
numbers increase.
A number divided by the next highest number approximates .6180 (13/21=.6190,
21/34=.6176, 34/55=.6181, 55/89=.6179 etc….). The approximation nears .6180 as the
numbers increase. This is the basis for the 61.8% retracement.
A number divided by another two places higher approximates .3820 (13/34=.382,
21/55=.3818, 34/89=.3820, 55/=144=3819 etc….). The approximation nears .3820 as the
numbers increase. This is the basis for the 38.2% retracement. Also, note that 1 - .618 =
.382
A number divided by another three places higher approximates .2360 (13/55=.2363,
21/89=.2359, 34/144=.2361, 55/233=.2361 etc….). The approximation nears .2360 as the
numbers increase. This is the basis for the 23.6% retracement.
1.618 refers to the Golden Ratio or Golden Mean, also called Phi. The inverse of 1.618 is .618.
These ratios can be found throughout nature, architecture, art and biology. In his book, Elliott
Wave Principle, Robert Prechter quotes William Hoffer from the December 1975 issue of
Smithsonian Magazine:
….the proportion of .618034 to 1 is the mathematical basis for the shape of playing cards and
the Parthenon, sunflowers and snail shells, Greek vases and the spiral galaxies of outer space.
The Greeks based much of their art and architecture upon this proportion. They called it the
golden mean.
Alert Zones
Retracement levels alert traders or investors of a potential trend reversal, resistance area or
support area. Retracements are based on the prior move. A bounce is expected to retrace a
portion of the prior decline, while a correction is expected to retrace a portion of the prior
advance. Once a pullback starts, chartists can identify specific Fibonacci retracement levels for
monitoring. As the correction approaches these retracements, chartists should become more alert
for a potential bullish reversal. Chart 1 shows Home Depot retracing around 50% of its prior
advance.
The inverse applies to a bounce or corrective advance after a decline. Once a bounce begins,
chartists can identify specific Fibonacci retracement levels for monitoring. As the correction
approaches these retracements, chartists should become more alert for a potential bearish
reversal. Chart 2 shows 3M (MMM) retracing around 50% of its prior advance.
Keep in mind that these retracement levels are not hard reversal points. Instead, they serve as
alert zones for a potential reversal. It is at this point that traders should employ other aspects of
technical analysis to identify or confirm a reversal. These may include candlesticks, price
patterns, momentum oscillators or moving averages.
Common Retracements
The Fibonacci Retracements Tool at Stockcharts shows four common retracements: 23.6%,
38.2%, 50% and 61.8%. From the Fibonacci section above, it is clear that 23.6%, 38.2% and
61.8% stem from ratios found within the Fibonacci sequence. The 50% retracement is not based
on a Fibonacci number. Instead, this number stems from Dow Theory's assertion that the
Averages often retrace half their prior move.
Shallow retracements occur, but catching these requires a closer watch and quicker trigger
finger. The examples below use daily charts covering 3-9 months. Focus will be on moderate
retracements (38.2-50%) and golden retracements (61.8%). In addition, these examples will
show how to combine retracements with other indicators to confirm a reversal.
Moderate Retracements
Chart 3 shows Target (TGT) with a correction that retraced 38% of the prior advance. This
decline also formed a falling wedge, which is typical for corrective moves. The combination
raised the reversal alert. Chaikin Money Flow turned positive as the stock surged in late June, but
this first reversal attempt failed. Yes, there will be failures. The second reversal in mid July was
successful. Notice that TGT gapped up, broke the wedge trendline and Chaikin Money Flow
turned positive (green line).
Chart 4 shows Petsmart (PETM) with a moderate 38% retracement and other signals coming
together. After declining in September-October, the stock bounced back to around 28 in
November. In addition to the 38% retracement, notice that broken support turned into resistance
in this area. The combination served as an alert for a potential reversal. William %R was trading
above -20% and overbought as well. Subsequent signals affirmed the reversal. First, Williams
%R moved back below -20%. Second, PETM formed a rising flag and broke flag support with a
sharp decline the second week of December.
Golden Retracements
Chart 4 shows Pfizer (PFE) bottoming near the 62% retracement level. Prior to this successful
bounce, there was a failed bounce near the 50% retracement. The successful reversal occurred
with a hammer on high volume and follow through with a breakout a few days later.
Chart 5 shows JP Morgan (JPM) topping near the 62% retracement level. The surge to the 62%
retracement was quite strong, but resistance suddenly appeared with a reversal confirmation
coming from MACD (5,35,5). The red candlestick and gap down affirmed resistance near the
62% retracement. There was a two day bounce back above 44.5, but this bounce quickly failed as
MACD moved below its signal line (red dotted line).
Conclusions
Fibonacci retracements are often used to identify the end of a correction or a counter-trend
bounce. Corrections and counter-trend bounces often retrace a portion of the prior move. While
short 23.6% retracements do occur, the 38.2-61.8% covers the more possibilities (with 50% in
the middle). This zone may seem big, but it is just a reversal alert zone. Other technical signals
are needed to confirm a reversal. Reversals can be confirmed with candlesticks, momentum
indicators, volume or chart patterns. In fact, the more confirming factors the more robust the
signal.
The Fibonacci Retracements Tool can be accessed when annotating a SharpChart. There are
three steps involved. First, click on the Fibonacci Retracements Tool icon at the top. Second,
move the cursor to the starting point, left click and hold. Third, drag the cursor to the ending
point and release the mouse button. The default 38.2%, 50% and 61.8% retracements will
appear. The actual price levels can be hidden/shown by holding the CRTL bottom and left
clicking on the top or bottom lines. To add the 23.6%, hold the CRTL button while selecting the
Fibonacci Retracements Tool and then draw as normal. This will also add a 161.80%
retracement.
Fibonacci Fan
Fibonacci Fan as a line instrument is built as follows: a trend line — for example from a trough
to the opposing peak is drawn between two extreme points. Then, an "invisible" vertical line is
automatically drawn through the second extreme point. After that, three trend lines intersecting
this invisible vertical line at Fibonacci levels of 38.2, 50, and 61.8 percent are drawn from the
first extreme point.
These lines are considered to represent support and resistance levels. For getting a more precise
forecast, it is recommended to use other Fibonacci instruments along with the Fan.
Fibonacci Channel
Fibonacci Channels are built using several parallel trend lines. To build this instrument, the
channel having the width taken as a unit width is used. Then, parallel lines are drawn at the
values equal to the Fibonacci Numbers, beginning with 0.618-fold size of the channel, then
1.000-fold, 1.618-fold, 2.618-fold, 4.236-fold, etc. As soon as the fifth wave finishes, correction
in the direction opposite to the trend can be expected.
It is necessary to remember for a correct Fibonacci Channel building: base line limits the upper
part of the channel when trend is ascending, and the lower part of it when trend is descending.
Fibonacci Arcs
Fibonacci Arcs are built as follows: first, the trend line is drawn between two extreme points, for
example, from the trough to the opposing peak. Then three arcs are built having their centers in
the second extreme point and intersecting the trend line at Fibonacci levels of 38.2, 50, and 61.8
per cent.
Fibonacci arcs are considered to be potential support and resistance levels. Fibonacci Arcs
andFibonacci Fans are usually plotted together on the chart, and support and resistance levels are
determined by the points of intersection of these lines.
It should be noted that the points of intersection of Arcs and the price curve can change
depending on the chart scale since an arc is a part of a circumference, and its form is always the
same.
To build this instrument, it is necessary to specify two points to determine the length of a unit
interval. All other lines are built on base of this unit interval according to Fibonacci Numbers.