Chapter 3 - Trend Analysis

Question 1

What is the accumulation phase?

Answer 1

In Dow Theory, the first phase in a bull market; it is the period when prices are depressed and financial reports are negative, but informed investors are buying in anticipation of a recovery.

Question 2

What is confirmation?

Answer 2

Occurs when indicators or signals are pointing in the same direction, therefore reaching the same conclusion or “confirming” each other.

Question 3

What is the distribution phase?

Answer 3

In Dow Theory, the first phase in a bear market; prices are high, and farsighted investors begin to sell.

Question 4

What is divergence?

Answer 4

The opposite of confirmation, also known as non-confirmation, when indicators do not confirm each other, which is an extremely valuable early warning signal of potential trend reversals.

Question 5

Describe what the Dow Theory is.

Answer 5

The theory that laid the foundation for modern technical analysis; it incorporates the concepts of trend identification and analysis, the principles of divergence and convergence, the importance of volume, and the use of percentage retracement.

Question 6

What is a downtrend?

Answer 6

When a market or security is trading in a pattern of lower highs and lower lows.

Question 7

What are fan lines?

Answer 7

A chart formation used to predict potential price objectives once a trendline is violated; lines are drawn from the initial point on the violated trendline using predetermined angles, with the result resembling a fan.

Question 8

What is a market profile chart?

Answer 8

A graphical representation that incorporates price, time and volume for one time period. A time-related distribution of trading activity at each price level.

Question 9

What is a minor trend?

Answer 9

The direction that prices are headed over a short period of time; usually the minor trend is opposite to the primary trend.

Question 10

What is on-balance volume (OBV)?

Answer 10

A cumulative total of upside and downside volume based on the underlying security’s close, which indicates buying or selling pressure.

Question 11

What is a primary trend?

Answer 11

The general direction in which prices are moving on a long-term chart.

Question 12

What is a resistance level?

Answer 12

The price point at which holders are willing to sell, but few investors are willing to buy; accordingly, prices have trouble rising above resistance.

Question 13

What is a secondary trend?

Answer 13

The general direction in which prices are moving on a medium-term (i.e., daily or weekly) chart; the secondary trend is usually opposite to the primary trend.

Question 14

What is a support level?

Answer 14

The price point at which investors are willing to buy, but few investors are willing to sell; accordingly, prices have trouble falling below support.

Question 15

What is a trend channel?

Answer 15

A formation in which prices move back and forth between parallel ascending or descending lines.

Question 16

What is a trendline?

Answer 16

A line connecting a series of ascending lows (in the case of an up trendline) or descending highs (in the case of a down trendline).

Question 17

What is an uptrend?

Answer 17

When a market or security is trading in a pattern of successive higher highs and
higher lows.

Question 18

What does it mean to get “WHIPSAWED?”

Answer 18

Taking a position in anticipation of a market moving in a certain direction, only to see the market reverse and go in the
opposite direction, forcing you out of the trade, and then reverse back to its original direction.

Question 19

What are the six basic tenets of the Dow Theory?

Answer 19

• The Averages (i.e., the Dow Jones Industrial Average, DJIA and the Dow Jones Transportation Average, DJTA) discount everything, reflecting both current and future expectations about general business conditions.
• The market has three different trends acting simultaneously: a primary trend, a secondary trend, and a minor trend.
• A primary trend has three phases, each of which describes certain characteristics of a bull or bear market.
• The direction of the DJIA and the DJTA must confirm each other, thereby providing confirmation of a change in the trend.
• Volume should expand in the direction of the prevailing trend.
• A trend should be assumed to persist until it gives definite signals that it has reversed.

IN SUMMARY:

• The averages discount everything
• The market has three trends
• Primary trends have three phases
• The averages must confirm each other
• Volume must confirm the trend
• A trend should be assumed to persist until it gives definite signals that it has reversed

Question 20

What are support and resistance levels?

Answer 20

• Support and resistance levels are used to determine critical price points, which if broken, may indicate a trend termination or reversal.
• A support level is the price point at which the strength of buyers outweighs that of sellers, thereby helping to keep the price from falling further.
• A resistance level is the price point at which the strength of sellers outweighs that of buyers, thereby helping to keep the price from rising higher.

Question 21

How does one identify support and resistance levels by observing a market profile chart?

Answer 21

• A market profile chart highlights support and resistance levels by identifying the prices at which volume was relatively light or relatively heavy.
• The market profile theory supports the idea that once a breakout above a resistance level (below a support level) occurs, this resistance (support) level reverses its role and becomes a future support (resistance) level.

BRACKETS ARE FOR THE OPPOSITE SCENARIO

Question 22

What are trendlines?

Answer 22

• A trendline is a line connecting a series of ascending lows (an uptrend) or descending highs (a downtrend).
• Once a trendline develops and assumes a certain slope, that slope tends to persist.
• Once established, upward sloping trendlines act as support, and downward sloping trendlines act as resistance.

Question 23

What is the significance of the slope of a trendline?

Answer 23

The steepness of the trendline in trading indicates the momentum of price movement; a steeper trendline suggests stronger momentum and more rapid price changes, while a flatter trendline indicates weaker momentum and slower price changes.

Question 24

Why must you pay attention to the angle of a trendline?

Answer 24

You have to pay attention to the angle of a trendline because the angle shows you exactly how strong the trend is. In an uptrend, a small angle means that the new lows are not moving up as fast. However, once the angle becomes too large, it often signals a trend (Boom) which is not sustainable.

NOTE: The greater the number of retests that a trendline has endured, the stronger the trendline.

Question 25

How can one identify areas of support and resistance?

Answer 25

MARKET PROFILE.

Question 26

Explain what market profile is.

Answer 26

Market Profile, a trading and charting technique
developed by Peter Steidlmayer, allows its followers to combine these three pieces of history and
project future support and resistance levels based on price and volume distributions. Market
Profile allows technicians to find price levels on a chart where high or low volume has occurred,
as well as what the market considers value areas (where 70% of volume has been traded). Originally developed for use in bond futures trading, a Market Profile chart records a letter for
each 30-minute time period. These accumulate during the day and form distribution patterns,
which highlight high- and low-volume areas. In essence, it is a time, price and volume chart that
can be used for identifying support and resistance levels
Remember, prices at high volume levels indicate market participants have strong emotional
and financial commitments made at these levels. Therefore, we expect them to act as support
and resistance levels in the future. The basic tenet of the psychology of support and resistance
levels is that what was once support can become resistance and vice versa. Low volume levels
also represent support and resistance in that the market has not traded there much or at all, and
investors will err on the side of caution and show a fear of the unknown. Steidlmayer’s research
has shown that these high- and low-volume areas tend to offer strong support and resistance levels
in the future. These support and resistance levels are also very good leading indicators, as strong
expectations can be based on them. Therefore, they carry a strong trading bias.

Question 27

What are value areas?

Answer 27

The value area represents the area of greatest trade facilitation and acceptance of value in the day timeframe and is signified by the price region where 70 percent of the day’s volume occurred.

Question 28

What is the significance of the value area?

Answer 28

By analyzing the value area, we can gain valuable insights into supply and demand, as well as potential price movements. It is a crucial term to familiarize oneself with when delving into the world of finance and trading.

Question 29

What is meant by the term “percent retracement?”

Answer 29

The amount that prices retreat following a higher-high can be measured using a technique referred to as “percent retracement.” This measures the percentage that prices “retraced” from the high to the low.

Question 30

What is the significance of percent retracement?

Answer 30

Measuring the percent retracement can be helpful when determining the price levels at which prices will reverse and continue upward. During a vigorous bull market, prices often retrace up to 33% of the original move. It is not uncommon for prices to retrace up to 50%.

Question 31

Explain the concept of on balance volume (OBV).

Answer 31

On balance volume (OBV) is a cumulative total of upside and downside volume based
on the underlying security’s close, and indicates buying or selling pressure. The total volume for each timeframe is either positive or negative, depending on whether the security closed higher
or lower. These values are then either added to, or subtracted from, a running cumulative total. OBV is plotted as a line, rising and falling depending on the direction of the price action. (Note that like most technical indicators, OBV can be applied to any timeframe. For example, 5-minute
intraday charts would use the volume corresponding to each 5-minute bar, for weekly charts it would be the weekly volume, etc.). It is the overall trend of the OBV line that is important, not the specific value. If prices are trending higher, so too should be the OBV line. OBV is used to either confirm a current price trend or warn of a possible trend reversal when it diverges from the price action or breaks key support.

On-Balance Volume (OBV) is a technical analysis indicator that accumulates volume based on whether a stock’s price closes higher or lower than the previous period. Here’s how it works:

• Calculation:
  
  • If the closing price is higher than the previous period, the volume is added to the OBV.
  • If the closing price is lower than the previous period, the volume is subtracted from the OBV.
  • If the closing price is the same, the OBV remains unchanged.

OBV is a running total and does not depend on a specific number of previous periods. It continually updates with each new data point.

In a 5-minute timeframe, the OBV is updated every 5 minutes using the current volume and the comparison of the current and previous 5-minute closing prices. The running total includes all historical data up to the current point.

Question 32

Explain why it is that the secondary trend is opposite to the primary trend.

Answer 32

When certain investors and traders start booking profits in the primary uptrend, we face a short-term reverse movement, which is popularly called a correction in the market. This correction in the market is nothing but a secondary trend. Think of this as a minor counter-reaction to the larger movement in the market.

Question 33

What does it mean for something to be already “discounted” in finance lingo?

Answer 33

It is already accounted for in whatever you are looking at.

Question 34

How are volume and the trend related?

Answer 34

Investors often use trading volume to confirm a trend’s existence or continuation, or a trend reversal. Trading volume can provide investors with a signal to enter the market. Trading volume can also signal when an investor should take profits and sell a security due to low activity.

• Low Volume: Indicates fewer shares are being traded. Often seen during less decisive market movements or when the market is less active.
• High Volume: Indicates a larger number of shares are being traded. Suggests strong interest and decisive action in the market, often accompanying significant price movements or trends.

Question 35

Can trendlines act as support and resistance?

Answer 35

YES!

Question 36

What does it mean if a trendline is tested many times?

Answer 36

The more a trendline is tested, the more valid the trend.

Question 37

What does capitulation mean in terms of the markets?

Answer 37

Market capitulation is a term used by investors and traders during times of market decline. It refers to an extreme point of panic selling, where investors are willing to sell their assets at any price, resulting in a rapid decline in prices.

Question 38

What is consolidation?

Answer 38

In technical analysis, consolidation is referred to the time period when a stock does not cross its support and resistance lines. Instead, the stock movement sticks to a well defined pattern that doesn’t rise over its previous high price, or doesn’t fall under its recent lowest price in the past.

Question 39

What is the “Principle of Polarity?”

Answer 39

The Principle of Polarity states that once a Resistance (Support) level is breached, it changes its nature and becomes Support (Resistance) the next time it is approached. This happens due to change in Demand and Supply.

Question 40

What does it mean to “go sideways?”

Answer 40

A sideways market, sometimes called sideways drift, refers to when asset prices fluctuate within a tight range for an extended period of time without trending one way or the other. Sideways markets are typically described by regions of price support and resistance within which the price oscillates.

Question 41

What does it mean for something to be “range bound?”

Answer 41

Whenever a stock or index is trading between support and resistance, it is called range-bound. There is no strong move in either direction. Prices tend to ping back and forth near old highs and then fall to prior lows.

Question 42

Explain the concept of fan lines.

Answer 42

There are several types of fan line projections to be aware of, but they all have the same basic
characteristics. They are another tool used to suggest where important reversal points and
subsequent support and resistance levels will occur. Fan lines are trendlines drawn at specific
angles from significant peaks or troughs, but are typically used when the initial trendline has
broken, and will be covered from this perspective. Fan lines are used to estimate where prices may
find support and where reaction rallies may find resistance. Once one fan line is penetrated, the
next fan line becomes support (see Figure 3.15). The fan line can usually be redrawn three times
before the entire rally will retrace (give back) its initial gains.
Fan line ratios were developed by W. D. Gann2 and by Leonardo Fibonacci.3 These ratios suggest
where prices are likely to find support or resistance, but they add very little value for trading
purposes. Fibonacci fan lines are commonly drawn at angles that correspond to retracements of
38.2%, 50% and 61.8% of the move being measured. Gann fan lines are typically drawn at the
fixed angles of 75º, 63.75º, 45º, 26.25º and 15º, but four other angles exist. Gann believed that
the most important angle is 45º, which is the perfect symmetry of time and price.

Question 43

What are the six basic tenets of Dow Theory?

Answer 43

• Th e Averages discount everything.
• Th e market has three trends.
• Primary trends have three phases.
• Th e Averages must confirm each other.
• Volume must confirm the trend.
• A trend should be assumed to persist until it gives definite signals that it has reversed.

Question 44

What are the three phases of primary trends?

Answer 44

A primary trend is usually characterized by three phases in both bull and bear markets. While not
all bull or bear markets are alike, they all share to various degrees certain characteristics. While
Dow’s generalizations do not appear verbatim in any given market move, they do provide the
technician with a helpful roadmap to use when charting the progress of a bull or bear market.

BULL MARKET PHASES

1. The first is the accumulation phase. It actually begins at the end of the last stage of a bear
   market. At this point, prices are depressed and financial reports are negative. Farsighted
   investors use this period to take advantage of low prices and buy shares from discouraged
   and distressed sellers. This phase is thus characterized by aggressive buying by informed
   investors in anticipation of an economic recovery and long-term growth. Activity is
   moderate but begins to increase on rallies.
2. In the second phase of a primary uptrend, corporate earnings begin to increase as economic
   conditions improve. The stronger tone of business and the rising trend in corporate earnings
   generates positive business reports that begin to attract attention in both the public and
   the media. The buying public begins to amass stock. In this phase, the trend-following
   technician may profit handsomely as prices, when in a highly positive market environment
   and impulsive wave structure, have the tendency to rally strongly.
3. A market rife with activity characterizes the third and final phase of the bull market, as the
   public has now become heavily involved. Record corporate earnings and peak economic
   conditions are reported often by the media in bullish stories and newscasts. Speculative
   volume increases in the market since the public has all but forgotten the last time the market
   was bearish. A buying frenzy is often seen as investors become convinced that the market
   is unstoppable and is the place to be. Those more astute investors who bought during
   the initial accumulation phase, however, begin to sell their holdings in anticipation of a
   downturn (see Figure 3.2).

BEAR MARKET PHASES

1. The first phase in a bear market is the distribution phase, which actually begins at the end
   of the last stage in a bull market). Farsighted investors observe the euphoria (with the help
   of statistical and sentiment indicators, which will be discussed later in the course), and begin
   selling their holdings at an increasing rate. While volume is still strong, it begins to weaken
   as oversupply leads to weakening prices. Basically, “informed” investors are selling, while
   “uninformed” investors and the general public continue to buy.
2. Th e second phase of a primary downtrend is characterized by near panic selling. Buyers
   become increasingly harder to find as sellers become more desperate. Prices begin to strongly
   accelerate downwards as more people try to liquidate their holdings. Volume is exceptionally
   strong in this phase as investors feed off one another’s shared panic. This serves to fuel both
   the speed and the weakness of an already falling market.
3. Th e final phase of a bear market sees discouraged investors, who held their stock throughout
   the panic in the second phase, finally capitulate and sell. This leads to further weakening
   and erosion of prices. The media is teeming with bearish headlines and news stories as the
   markets continue to fall from distressed selling by those willing to “get out at any price.”
   Th e bear market ends when all the bad news is finally discounted by the market. Those
   more astute investors who sold during the initial distribution phase, now begin to buy in
   anticipation of an upturn (see Figure 3.3).

Question 45

How can one distinguish a significant break from a minor penetration?

Answer 45

Even if a long-term trendline that has been tested many times is violated, technicians still look to
the following rules of thumb to distinguish a significant break from a minor penetration:
1. two daily closes above the down trendline or below the up trendline
2. significant increase in volume, particularly when breaking a down trendline
3. weekly close above the down trendline or below the up trendline
4. penetration above or below the trend by more than 3% (i.e., a $50 stock would need to
break by $1.50 or more)