Stock market trends: the behaviour of a chartist

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Stock market trends the behaviour of a chartist

• By Enrico Grassi

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The head and shoulders formation can be bullish
or bearish, its typical formation is the
following  
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Let us examine the bearish formation in
detail the neckline may be
horizontal as in the figure or ascending /
descending, the shoulders may be at the same
price level or at different levels, these
variations to respect to the typical formation
gives the trader additional information as to the
degree of probability that the formation will
follow up with a break through, i.e. a descending
neckline as well as a lower right shoulder raises
the probability of a successful pattern
formation, on the other hand an ascending
neckline as well as a higher right shoulder
decreases the probability of a successful
formation.
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In his book The Psychology of Technical
Analysis Tony Plummer traces a theory that tries
to explain the origin of the pattern as a
consequence of natural non linear dynamic systems
due to the negative feed back loops. The mutual
development between a system and the environment
involves an interesting and important concept of
co-evolution. The first works on the subject are
due to Vito Volterra 1926 and continued by Alfred
Lotka in 1956, the theory was further developed
by biologists Paul Ehrlich and Peter Raven in
1965.
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The market place can be viewed as an eternal
battle between to crowds of people the bullish
crowd and the bearish crowd. If the bull crowd is
in majority the market is under buying pressure
and prices rise, if the bears are in majority the
market is under selling pressure and prices
decline. The battle between bulls and bears is
similar to that of predators and prey in nature.
The two crowds participate in a cycle that can be
represented as follows  
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  The diagram represents a limit cycle and helps
us see the relationship between the two crowds
in A we have the max of the bull crowd, in B the
bull crowd is dropping and the bear crowd is
gaining, in C the bear crowd has reached its
climax as the bull crowd has reached its min., in
D bull crowd is growing again as the bear crowd
declines.
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Similar is the diagram between prices and
sentiment of the market players.    
  In A we have high prices and sentiment
has still little to grow, In B both prices a
sentiment are dropping, in C prices are at a low
as sentiment has still some more to go down, in D
prices are picking up quickly as sentiment
follows.
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This sort of cycle would produce a stabile price
oscillation in time, it is the action of shocks
to the system which generate the head and
shoulder formation. Shocks accelerate the
ascending and descending stages, the system
reacts to the shocks as to re-establish the main
cycle, in the phase diagram spirals are generated
( Plummer assumes golden ratio spirals and so
connects the process to Fibonacci series).
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Let us trace the cycle in a price sentiment
frame and see how the head and shoulder formation
generates.  
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LINE CHART
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A line chart is the simplest type of chart. One
price (typically the close) is plotted for each
time period (i.e., day, week, month, etc.). A
single, unbroken line connects each of these
price points.
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BAR CHART
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CANDLESTICK CHART
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The Japanese developed a method of technical
analysis in the 1600s to analyze the price of
rice contracts. This technique is called
Candlestick charting. Candlestick charts display
the open, high, low, and closing prices in a
format similar to a modern-day bar-chart.
Articles written by Steven Nison that explain
Candlestick charting appeared in the December,
1989 and April, 1990 issues of Futures Magazine.
The definitive book on the subject is Japanese
Candlestick Charting Techniques also by Steve
Nison (see Suggested Reading). Some investors are
attracted to Candlestick charts by their
mystique--maybe they are the "long forgotten
Asian secret" to investment analysis. Other
investors may be turned-off by their mystique.
Regardless of your feelings about the mystique of
Candlestick charting, we strongly encourage you
to explore their use. Candlestick charts
dramatically illustrate supply/demand concepts
defined by classical technical analysis theories.
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EQUIVOLUME CHART
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Developed by Richard W. Arms, Jr., and explained
in his book Volume Cycles in the Stock Market
(see Suggested Reading), Equivolume presents a
highly informative picture of market activity for
stocks, futures, and indices. Equivolume departs
from other charting methods with its emphasis on
volume as an equal partner with price. Instead
of being displayed as an "afterthought" on the
lower margin of a chart, volume is combined with
price in a two-dimensional box. The top line of
the box is the high for the period and the bottom
line is the low for the period. The width of the
box is the unique feature of Equivolume charting
it represents the volume of trading for the
period. The width of the box is controlled by a
normalized volume value. The volume for an
individual box is normalized by dividing the
actual volume for the period by the total of all
volume displayed on the chart. Therefore, the
width of each Equivolume box is based on a
percentage of total volume, with the total of all
percentages equaling 100.
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The resulting charts represent an important
departure from all other analytical methods, in
that time becomes less important than volume in
analyzing price moves. It suggests that each
movement is a function of the number of shares or
contracts changing hands rather than the amount
of time elapsed. Perhaps the Equivolume charting
method is best summed up by the developer himself
as follows "If the market wore a wristwatch, it
would be divided into shares, not hours."
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CANDLE VOLUME CHART
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THREE LINE BREAK CHART
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Three Line Break charts originate from Japan and
were introduced to the western world by Steve
Nison (a well-known authority on the Candlestick
charting method). The Three Line Break charting
method gets its name from the default number of
line blocks typically used. Using the closing
price, a new white block is added in a new column
if the previous high price is exceeded. A new
black block is drawn if the close makes a new
low. If there is neither a new high or low,
nothing is drawn. With a default Three Line
Break, if a rally is powerful enough to form
three consecutive white blocks, then the low of
the last three white blocks must be exceeded
before a black block is drawn. If a sell-off is
powerful enough to form three consecutive black
blocks, then the high of the last three black
blocks must be exceeded before a white block is
drawn.
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To draw line break blocks, today's close is
compared to the high and low of the previous
block. A block is drawn only when today's close
exceeds the high or low of the previous block.
If today's close is higher than the top of the
previous block, a new white block is drawn in the
next column from the prior high to the new high
price. If today's close is lower than the bottom
of the previous block, a new black block is drawn
in the next column from the prior low to the new
low price. If the close fails to move outside
the range of the previous blocks high or low,
then nothing is drawn. With the default Three
Line Break chart, a downside reversal (i.e.,
white blocks change to black blocks) occurs when
the price moves under the lowest price of the
last three consecutive white blocks. A black
reversal block is drawn from the bottom of the
highest white block to the new price. An upside
reversal (i.e., black blocks change to white
blocks) occurs when the price moves above the
highest price of the last three consecutive black
blocks. A white reversal block is drawn from the
top of the lowest black block to the new high
price.
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KAGI CHART
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Kagi charts are thought to have been created
around the time the Japanese stock market started
trading in the 1870s. Kagi charts were
introduced to the western world by Steve Nison (a
well-known authority on the Candlestick charting
method). Kagi charts display a series of
connecting vertical lines where the thickness and
direction of the lines are dependent on the price
action. If closing prices continue to move in
the direction of the prior vertical Kagi line,
that line is extended. However, if the closing
price reverses by a pre-determined "reversal"
amount, a new Kagi line is drawn in the next
column in the opposite direction. An interesting
aspect of the Kagi chart is that when closing
prices penetrate the prior column's high or low,
the thickness of the Kagi line changes.
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To draw Kagi lines, compare the close to the
ending point of the last Kagi line. If the price
continues in the same direction as the prior
line, the line is extended in the same direction,
no matter how small the move. However, if the
closing price moves in the opposite direction by
the reversal amount or more (this could take a
number of sessions), then a short horizontal line
is drawn to the next column and a vertical line
is continued to the new closing price. If the
closing price moves in the opposite direction of
the current column by less than the reversal
amount then no lines are drawn. In addition, if
a thin Kagi line exceeds the prior high point (on
the Kagi chart), the line becomes thick.
Likewise, if a thick Kagi line breaks a prior low
point, the line becomes thin.
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RENKO CHART
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The Renko charting method is thought to have
acquired its name from "renga" which is the
Japanese word for bricks. Renko charts were
introduced by Steve Nison (a well-known authority
on the Candlestick charting method). Renko charts
are similar to Three Line Break charts except
that in a Renko chart, a line (or brick as they
are sometimes called) is drawn in the direction
of the prior move only if a fixed amount (i.e.,
the box size) has been exceeded. The bricks are
always equal in size. For example, in a five
unit Renko chart, a 20 point rally is displayed
as four equally sized, five unit high Renko bricks
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To draw Renko bricks, today's close is compared
with the high and low of the previous brick
(white or black). When the closing price rises
above the top of the previous brick by the box
size or more, one or more equal height, white
bricks are drawn in the next column. If the
closing price falls below the bottom of the
previous brick by the box size or more, one or
more equal height, black bricks are drawn in the
next column. If the market moves up more than
the amount required to draw one brick, but less
than the amount required to draw two bricks, only
one brick is drawn. For example, in a two unit
Renko chart, if the base price is 100 and the
market moves to 103, then one white brick is
drawn from the base price of 100 to 102. The
rest of the move--from 102 to 103--is not shown
on the Renko chart. The same rule applies
anytime the price does not fall on a box size
divisor.
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POINT FIGURE CHART
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Point figure (PF) charts differ from "normal"
price charts in that they completely disregard
the passage of time and only chart changes in
prices. Rather than having price on the y-axis
and time on the x-axis, PF charts display price
changes on both axes. PF charts display an "X"
when prices rise by the "box size" and display an
"O" when prices fall by the box size. Note that
no Xs or Os are drawn if prices rise or fall by
an amount that is less than the box size. Each
column can contain either Xs or Os, but never
both. In order to change columns (e.g., from an
X column to an O column), prices must reverse by
the "reversal amount" multiplied by the box size.
For example, if the box size is 3 points and the
reversal amount is 2 boxes, then prices must
reverse direction 6 points (3 times 2) in order
to change columns. If you are in a column of Xs,
the price must fall 6 points in order to change
to a column of Os. If you are in a column of Os,
the price must rise 6 points in order to change
to a column of Xs. The changing of columns
signifies a change in the trend of prices.
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Because prices must reverse direction by the
reversal amount, each column in a PF chart will
have at least "reversal amount" boxes. When in a
column of Xs or Os, MetaStock will first check to
see if prices have moved in the current direction
(e.g., rose if in a column of Xs or fell if in a
column of Os) before checking for a reversal.
MetaStock uses the high and low prices to decide
if prices have changed enough to display a new
box.
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LONG STM EQUIVOLUME CHART
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LONG STM RENKO CHART
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Conclusion Charting techniques help the trader
visualize promising patterns. Chart analysis is
part of technical analysis, technical analysis is
not the only way to go, a trader should in my
view also do some fundamental analysis and
protect his money with a sound money management
technique. The head and shoulders formation is
very common and in this paper I have tried to
give it a sound natural basis.
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• References
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• T. Plummer, The psychology of technical analysis,
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• J.E. Murphy, Jr., Stock market probability,
  Probus Publishing Company, Chicago,1991
• J.J.Murphy, Technical analysis of the futures
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  York,1986
• F.E. Cirio, Guida pratica ai futures su indici
  azionari, Il sole 24ore libri, Milano,1992
• S. Nison, Japanese candlstick charting
  techniques, New York Institute of Finance, New
  York,1991
• S. Nison, Beyond candlesticks, John Wiley Sons,
  Inc., New York, 1994
• R.W. Arms, Jr., Volume cycles in the stock
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• L.G. McMillan, Options as a Strategic Investment,
  New York Institute of Finance, New York,1993
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