Lecture 3 Technical Analysis

Lecture 3 Technical Analysis
Primary Texts Edwards and Ma: Chapter 16 CME: Chapter 8 Web Resources

Technical Analysis: Technical analysis is the study of historical prices for the purpose of predicting prices in the future Technical analysts frequently utilize charts of past prices to identify historical price patterns These price patterns are then used to forecast prices in the future A basic belief of technical analysts is that market prices themselves contain useful and timely information Prices quickly reflect all available fundamental information, as well as other information, such as traders’ expectations and the psychology of the market Role of Technical Analysis Identify and predict changes in direction of price trends Determine the timing of action – entry and exit decisions

Technical Analysis: Chart Analysis
Chart Analysis - the basic tool of technical analysis A price chart is a sequence of prices plotted over a specific time frame. In statistical terms, charts are referred to as time series plots Chart analysts plots historical prices in a two-dimensional graph in order to identify price patterns which can then be used to predict the futures direction of prices The goal of any chart analyst is to find consistent, reliable, and logical price patterns with which to predict future price movements Chart analysts rely primarily on three bodies of data Prices (monthly, weekly, daily, and intra-day) Trading volumes, and Open interest

Technical Analysis: Chart Analysis
Price Pattern Recognition Charts The most commonly used price pattern recognition charts are: bar charts, line charts, candlestick charts, and point-and-figure charts On these charts, the Y-axis (vertical axis) represents the price scale and the X-axis (horizontal axis) represents the time scale. Prices are plotted from left to right across the X-axis with the most recent plot being the furthest right. Bar Charts: Bar charts mark trading activity of a specified trading period (e.g., day) by a single vertical line on the graph This line connects the high and low prices for the trading period The closing price is indicated by a horizontal bar

Technical Analysis: Chart Analysis – Bar Chart

Technical Analysis: Chart Analysis – Bar Chart
Bar charts can also be displayed using the open, high, low and close. The only difference is the addition of the open price, which is displayed as a short horizontal line extending to the left of the bar.

Technical Analysis: Chart Analysis – Line Charts
In a line chart, only the closing prices are plotted for each time period. Some investors and traders consider the closing level to be more important than the open, high or low. By paying attention to only the close, intraday swings can be ignored.

Technical Analysis: Chart Analysis – Candlestick Charts
Originating in Japan over 300 years ago, candlestick charts have become quite popular in recent years. For a candlestick chart, the open, high, low and close are all required. Hollow (clear) candlesticks form when the close is higher than the open and Filled (solid) candlesticks form when the close is lower than the open. The white and black portion formed from the open and close is called the body (white body or black body). The lines above and below are called shadows and represent the high and low. A daily candlestick is based on the open price, the intraday high and low, and the close. A weekly candlestick is based on Monday's open, the weekly high-low range and Friday's close.

Common Shapes of Candles

Bulls vs. Bears A candlestick depicts the battle between Bulls (buyers) and Bears (sellers) over a given period of time. Long white candlesticks indicate that the Bulls controlled trading for most of the period – buying pressure. Long black candlesticks indicate that the Bears controlled trading for most of the period – selling pressure. Small candlesticks indicate that neither the bulls nor the bears were in control of trading – consolidation. A long lower shadow indicates that the Bears controlled trading for some time, but lost control by the end and the Bulls made an impressive comeback. A long upper shadow indicates that the Bulls controlled trading for some time, but lost control by the end and the Bears made an impressive comeback. A long upper and lower shadow indicates that both the Bears and Bulls had their moments during the trading period, but neither could put the other away, resulting in a standoff.

Hollow vs. Filled Candlesticks Hollow candlesticks, where the close is higher than the open, indicate buying pressure. Filled candlesticks, where the close is lower than the open, indicate selling pressure. Long vs. Short Bodies Generally speaking, the longer the body is, the more intense the buying or selling pressure. Long white candlesticks show strong buying pressure – buyers are aggressive. Long black candlesticks show strong selling pressure – sellers are aggressive. Conversely, short candlesticks indicate little price movement and represent consolidation.

White vs. Black Marubozus Even more potent long candlesticks are the Marubozu brothers, Black and White. Marubozu do not have upper or lower shadows and the high and low are represented by the open or close. A White Marubozu forms when the open equals the low and the close equals the high. This indicates that buyers controlled the price action from the first trade to the last trade. A black Marubozu forms when the open equals the high and the close equals the low. This indicates that sellers controlled the price action from the first trade to the last trade.

Long vs. Short Shadows Candlesticks with short shadows indicate that most of the trading action was confined near the open and close. Candlestick with long shadows show that trades extended well past the open and close Candlesticks with a long upper shadow and short lower shadow indicate that buyers dominated during the session, and bid prices higher. However, sellers later forced prices down from their highs, and the weak close created a long upper shadow. Conversely, candlesticks with long lower shadows and short upper shadows indicate that sellers dominated during the session and drove prices lower. However, buyers later resurfaced to bid prices higher by the end of the session and the strong close created a long lower shadow.

Doji Doji form when a security's open and close are virtually equal. The length of the upper and lower shadows can vary and the resulting candlestick looks like a cross, inverted cross or plus sign. Alone, doji are neutral patterns. Doji convey a sense of indecision or tug-of-war between buyers and sellers. Prices move above and below the opening level during the session, but close at or near the opening level. The result is a standoff. Neither bulls nor bears were able to gain control and a turning point could be developing. Doji indicate that the forces of supply and demand are becoming more evenly matched and a change in trend may be near. Doji alone are not enough to mark a reversal and further confirmation may be warranted. The relevance of a doji depends on the preceding trend or preceding candlesticks.

Doji and Trend After an advance or long white candlestick, a doji signals that buying pressure may be diminishing and the uptrend could be nearing an end. However, even after the doji forms, further downside is required for bearish confirmation. This may come as a decline below the long white candlestick's open. After a decline or long black candlestick, a doji indicates that selling pressure may be diminishing and the downtrend could be nearing an end. However, further strength is required to confirm any reversal. Bullish confirmation could come as an advance above the long black candlestick's open.

Long Shadow Reversal There are two pairs of single candlestick reversal patterns made up of a small real body, one long shadow and one short or non-existent shadow. Generally, the long shadow should be at least twice the length of the real body, which can be either black or white. Hammer and Hanging Man: consists of identical candlesticks with small bodies and long lower shadows. The Hammer is a bullish reversal pattern that forms after a decline. A Hammer signals a potential trend reversal - that buying pressure is starting to increase. In addition, hammers can mark bottoms or support levels. The Hanging Man is a bearish reversal pattern that forms after an advance. Hanging Man signals that selling pressure is starting to increase. It can also mark a top or resistance level.

Inverted Hammer and Shooting Star The Inverted Hammer and Shooting Star look exactly alike, but have different implications based on previous price action. Both candlesticks have small real bodies (black or white), long upper shadows and small or nonexistent lower shadows. These candlesticks mark potential trend reversals, but require confirmation before action. The inverted hammer is a bullish reversal pattern that forms after a decline or downtrend. In addition to a potential trend reversal, inverted hammers can mark bottoms or support levels. The shooting star is a bearish reversal pattern that forms after an advance. A shooting star signals that selling pressure is starting to increase. It can also mark a top or resistance level.

Technical Analysis: Common Technical Price Patterns
Chart analysis uses both trend lines and geometric formations to predict market tops and bottoms, as well as future price movements The most popular technical price patterns are Support and Resistance, Trend lines, Double tops and bottoms, and Head-and-shoulder. Support and Resistance A support level is a price level at which there appears to be substantial buying pressure to keep prices from falling further A resistance level is a price level at which there appears to be substantial selling pressure to keep prices from rising further A congestion area occurs when prices move sideways, fluctuating up and down within a well defined range for a considerable time period

Dow theory Charles H. Dow (1851 – 1902)
Its emphasis on studying trends and price action forms the main premises of modern technical analysis Six basic tenets The market has three movements (or trends) Market trends have three phases The stock market discounts all news (agree with EMH) Stock market averages must confirm each other (manufacturing and transportation) Trends are confirmed by volume (see OBV) Trends exist until definitive signals prove that they have ended (should not be fooled by ‘market noises’)

1st tenet of Dow theory (cont) Three types of movements or trends
“Tertiary” 3 Trends: Primary: Months or years, Intermediate, Daily to Weekly, maybe a month, Minor is mostly intraday and can be ignored. Every stock has price peaks and troughs but if a series of peaks and troughs are rising it is a buy signal especially if volume is heavier during the peaks than the troughs 21

Support and resistance

Technical Analysis: Support and Resistance
A support level is a price level at which there appears to be substantial buying pressure to keep prices from falling further As the price declines towards support and gets cheaper, buyers become more inclined to buy and sellers become less inclined to sell. By the time the price reaches the support level, it is believed that demand will overcome supply and prevent the price from falling below support. Support can be established with the previous reaction lows. A resistance level is a price level at which there appears to be substantial selling pressure to keep prices from rising further As the price advances towards resistance, sellers become more inclined to sell and buyers become less inclined to buy. By the time the price reaches the resistance level, it is believed that supply will overcome demand and prevent the price from rising above resistance. Resistance can be established with the previous reaction highs.

Technical Analysis: Common Technical Price Patterns

Another principle of technical analysis is that support can turn into resistance and visa versa. Once the price breaks below a support level, the broken support level can turn into resistance. The break of support signals that the forces of supply have overcome the forces of demand. Therefore, if the price returns to this level, there is likely to be an increase in supply, and hence resistance. The other turn of the coin is resistance turning into support. As the price advances above resistance, it signals changes in supply and demand. The breakout above resistance proves that the forces of demand have overwhelmed the forces of supply. If the price returns to this level, there is likely to be an increase in demand and support will be found.

Technical Analysis: Congestion Area – Trading Range
A congestion area occurs when prices move sideways, fluctuating up and down within a well defined range for a considerable time period A congestion area signals that the forces of supply and demand are evenly balanced. When the price breaks out of the congestion area , above or below, it signals that a winner has emerged - A break above is a victory for the bulls (demand) and a break below is a victory for the bears (supply). When the price breaks out of the congestion area by penetrating the support it is a signal to sell. When the price breaks out of the congestion area by penetrating resistance it is a signal to buy.

Technical Analysis: Congestion Area – Trading Range

Technical Analysis: Support and Resistance Zones
Because technical analysis is not an exact science, it is sometimes useful to create support and resistance zones. Sometimes, exact support and resistance levels are best, and, sometimes, zones work better. Generally, the tighter the range, the more exact the level. If the trading range spans less than 2 months and the price range is relatively tight, then more exact support and resistance levels are best suited. If a trading range spans many months and the price range is relatively large, then it is best to use support and resistance zones. These are only meant as general guidelines, and each trading range should be judged on its own merits.

Technical Analysis: Support and Resistance Zones

Identification of key support and resistance levels is an essential ingredient to successful technical analysis. Even though it is sometimes difficult to establish exact support and resistance levels, being aware of their existence and location can greatly enhance analysis and forecasting abilities. If a futures contract is approaching an important support level, it can serve as an alert to be extra vigilant in looking for signs of increased buying pressure and a potential reversal. If a futures contract is approaching a resistance level, it can act as an alert to look for signs of increased selling pressure and potential reversal. If a support or resistance level is broken, it signals that the relationship between supply and demand has changed. A resistance breakout signals that demand (bulls) has gained the upper hand and a support break signals that supply (bears) has won the battle.

Exponential Moving Average (EMA)
Also known as Exponentially Weighted Moving Average (EWMA) MA is equally weighted; EMA is exponentially weighted, with more weights allocated to recent past Formula: EMAt = a x Pt + (1-a) x Pt-1 where a = 2/(N+1)

Moving Average (MA) A moving average is commonly used to smooth out short-term fluctuations (or noise) and highlight longer-term trends or cycles. Formula: MA(n)t = (Pt + … + Pt-n+1)/n Crossing the MA from above (below) is a bear (bull) signal. Trading rule based on fast and slow MA’s: buy (sell) when fast MA crosses slow MA from below (above)

Trends and Turning Points
MA, EMA can be used for identifying trends MACD can be used for detecting possible reversal of trends – more responsive to newly established trends

Identifying trends using moving averages
Fast MA (21 day) EMA (21 day) Slow MA (63 day) MA crossover: buy signal Note: MA smooths out short-term or noises and highlight longer-term trends It is regarded as bullish if price stays above MA and/or MA is increasing Price tends to revert to MA when it is too far away from MA

Moving Average Convergence/Divergence (MACD)
Can be used to spot changes in the strength and direction of a trend in a stock's price. Calculation MACD = EMA(P,a) – EMA(P,b) where a<b Signal = EMA(MACD,c) Histogram = MACD – signal Not useful for stocks that are not trending or are trading erratically. One popular short-term set-up, for example, is setting (a,b,c) = (5,35,5).

An example of MACD

Application of MACD Three meaningful signals generated by the MACD indicator when: the MACD line crosses the signal line Buy (Sell) when MACD crosses from below (above) the MACD line crosses zero Bullish (Bearish) trend if MACD moves from -ve (+ve) to +ve (-ve) NB: Zero crossover lags signal line crossover there is a divergence between the MACD line and the price of the stock or between the histogram and the price of the stock higher highs (lower lows) on the price graph but not on the MACD line (or the bar graph), suggesting the bullish trend may not continue

Inherent dilemma with technical analysis
Since the MACD measures the divergence between averages, it can only give meaningful feedback as trends change The MACD is less useful if the market is trading sideways The MACD can generate false signals. E.g., A false positive would be a bullish crossover followed by a sudden decline in a stock. An example of prudent strategy would be to buy only if the MACD line breaks above the signal line and remains above it for three days As with any technical trading strategy, this reduces the probability of false signals but increases the frequency of missed profit or cost which may eventually render the strategy unprofitable

Trend or Range trading

The Relative Strength Index (RSI)
Computes momentum (the rate of the rise or fall in price) as the ratio of higher closes to lower closes For each trading period, If price goes up, U=closet – closet-1, D=0 If price goes down, U=0, D=closet-1 – closet RS = EMA(U,n)/EMA(D,n) RSI = 100 – 100/(1+RS) Hence, stocks which have had more or stronger positive changes have a higher RSI than stocks which have had more or stronger negative changes. Measured on a scale from 0 to 100, often with high and low levels marked at 70 and 30, respectively. n = 10 or 14 typically.

RSI Overbought/oversold Can be used for Range Trading
Wilder considered RSI overbought above 70 and oversold below 30 Overbought and oversold readings for RSI work best when prices move sideways within a range Caution: RSI can become overbought (oversold) and remain so in a strong up (down) trend

RSI and Trends RSI tends to fluctuate between 40 and 90 in a bull market (uptrend) with the zones acting as support (see right top) RSI tends to fluctuate between 10 and 60 in a bear market (downtrend) with the zone acting as resistance (see right bottom) RSI as overbought/oversold or divergence indicator fails in this case

RSI: Bullish/bearish divergence for trend reversal
A bullish divergence occurs when the underlying security makes a lower low and RSI forms a higher low A bearish divergence forms when the security records a higher high and RSI forms a lower high Wilder noticed that divergences signal a potential reversal point Caution: Divergences can be misleading in a strong trend

On-balance volume (OBV)
OBV is intended to relate price and volume in the stock market. The formula OBVt = OBVt-1 + v v = +volume, 0 or –volume if price closes up, unchanged or down OBV is generally used to confirm price moves. When prices are going up, OBV should be going up too If prices make a new rally high, then OBV should too. If OBV fails to go past its previous rally high, then this is a negative divergence, suggesting a weak move

OBV: Trend confirmation
OBV can be used to confirm a price trend, upside breakout or downside break. The chart for Best Buy (BBY) shows three confirming signals as well as confirmation of the price trend. OBV and BBY moved lower in December-January, higher from March to April, lower from May to August and higher from September to October. The trends in OBV matched the trend in BBY

OBV: Divergences A bullish divergence forms when OBV moves higher or forms a higher low even as prices move lower or forge a lower low (see right) A bearish divergence forms when OBV moves lower or forms a lower low even as prices move higher or forge a higher high. The divergence between OBV and price should alert chartists that a price reversal could be in the making.

More examples on OBV divergences

Market indicator Breath & cumulative breath
Breadth is the extent to which movements in a broad index are reflected widely in movements of individual stocks Measured as the difference between the number of advancing and declining stocks Cumulative breadth is found by adding the current day’s net advances or declines to the previous day’s total. The purpose is to gauge the trend. 49

Technical Analysis: Trend Lines
Technical analysis is built on the assumption that prices trend. A common trading strategy is to identify a price trend and then go with the trend. A trend line is a straight line that connects periodic highs or lows on a price chart and then extends into the future to act as a line of resistance or support. Two common types of trend lines Uptrend lines Downtrend lines

Technical Analysis: Uptrend Lines
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. When price falls below the uptrend line, this is a signal to sell or go short.

Technical Analysis: Uptrend Line

Technical Analysis: Downtrend Lines
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. When price breaks above the downtrend line, this is a signal to buy or go long.

Technical Analysis: Downtrend Line

Technical Analysis: Trend Lines - Conclusions
The general rule in technical analysis is that it takes two points to draw a trend line and the third point confirms the validity. 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. Trend lines can offer great insight, but if used improperly, they can also produce false signals Trend lines should not be the final arbiter, but should serve merely as a warning that a change in trend may be imminent.

Technical Analysis: Double Tops or Bottoms
Double tops or bottoms are frequently used to identify a price reversal. In an uptrend, the failure of prices to exceed a previous price peak on two occasions is considered a double top. This is a warning signal that the uptrend may be about to end and a downtrend to commence However, the formation of a double top is not considered confirmed until falling prices penetrate the previous low from the above. A double bottom is just the mirror image of a double top. In a downtrend, the failure of prices to penetrate previous support levels on two occasions is considered a double bottom. This is a warning signal that the downtrend may be about to end and an uptrend to commence

Technical Analysis: Double Tops

Technical Analysis: Double Tops
Prior Trend: In the case of the double top, a significant uptrend should be in place. First Peak: The first peak should mark the highest point of the current trend. Trough: After the first peak, a decline takes place that typically ranges from 10 to 20%. Second Peak: The advance off the lows usually occurs with low volume and meets resistance from the previous high. Resistance from the previous high should be expected. Usually a peak within 3% of the previous high is adequate. Decline from Peak: The subsequent decline from the second peak should witness an expansion in volume and/or an accelerated descent, perhaps marked with a gap or two. Support Break: Breaking support from the lowest point between the peaks completes the double top. This too should occur with an increase in volume and/or an accelerated descent. Support Turned Resistance: Broken support becomes potential resistance and there is sometimes a test of this newfound resistance level with a reaction rally. Such a test can offer a second chance to exit a position or initiate a short. Price Target: The distance from support break to peak can be subtracted from the support break for a price target. This would infer that the bigger the formation is, the larger the potential decline.

Technical Analysis: Double Bottoms

Technical Analysis: Double Bottoms
Prior Trend: In the case of the double bottom, a significant downtrend should be in place. First Trough: The first trough should mark the lowest point of the current trend. Peak: After the first trough, an advance takes place that typically ranges from 10 to 20%. Second Trough: The decline off the reaction high usually occurs with low volume and meets support from the previous low. Support from the previous low should be expected. While exact troughs are preferable, there is some room to maneuver and usually a trough within 3% of the previous is considered valid. Advance from Trough: Volume is more important for the double bottom than the double top. There should be clear evidence that volume and buying pressure are accelerating during the advance off of the second trough. Resistance Break: Breaking resistance from the highest point between the troughs completes the double bottom. This too should occur with an increase in volume and/or an accelerated ascent. Resistance Turned Support: Broken resistance becomes potential support and there is sometimes a test of this newfound support level with the first correction. Such a test can offer a second chance to close a short position or initiate a long. Price Target: The distance from the resistance breakout to trough lows can be added on top of the resistance break to estimate a target. This would imply that the bigger the formation is, the larger the potential advance.

Technical Analysis: Double Tops and Bottoms
60-70% reliable Frequently seen in grains and livestock commodities On 2 consecutive days or across several weeks

Technical Analysis: Head-and-Shoulders Tops or Bottoms
Head-and-Shoulders formations are among the most frequently used technical patterns for identifying a price reversal. Head-and-Shoulders formations consist of four phases: The left shoulder The head The right shoulder The penetration of the neckline A head-and-shoulder reversal pattern is complete only when the neckline is penetrated, either in an upward or downward direction. Head-and-Shoulder top: The formation is complete when price penetrate the neckline from above indicating a reversal from a uptrend to a downtrend. Head-and-Shoulder bottom: The formation is complete when price penetrate the neckline from below indicating a reversal from a downtrend to an uptrend.

Technical Analysis: Head-and-Shoulders Top

Technical Analysis: Head-and-Shoulders Tops
Prior Trend: Without a prior uptrend, there cannot be a Head and Shoulders reversal pattern. Left Shoulder: While in an uptrend, the left shoulder forms a peak that marks the high point of the current trend. After making this peak, a decline ensues to complete the formation of the shoulder (1). The low of the decline usually remains above the trend line, keeping the uptrend intact. Head: From the low of the left shoulder, an advance begins that exceeds the previous high and marks the top of the head. After peaking, the low of the subsequent decline marks the second point of the neckline (2). The low of the decline usually breaks the uptrend line, putting the uptrend in jeopardy. Right Shoulder: The advance from the low of the head forms the right shoulder. This peak is lower than the head (a lower high) and usually in line with the high of the left shoulder. While symmetry is preferred, sometimes the shoulders can be out of whack. The decline from the peak of the right shoulder should break the neckline. Neckline: The neckline forms by connecting low points 1 and 2. Low point 1 marks the end of the left shoulder and the beginning of the head. Low point 2 marks the end of the head and the beginning of the right shoulder. Depending on the relationship between the two low points, the neckline can slope up, slope down or be horizontal.

Technical Analysis: Head-and-Shoulders Tops
Volume: As the Head and Shoulders pattern unfolds, volume plays an important role in confirmation. Ideally, but not always, volume during the advance of the left shoulder should be higher than during the advance of the head. This decrease in volume and the new high of the head, together, serve as a warning sign. The next warning sign comes when volume increases on the decline from the peak of the head. Final confirmation comes when volume further increases during the decline of the right shoulder. Neckline Break: The head and shoulders pattern is not complete and the uptrend is not reversed until neckline support is broken. Ideally, this should also occur in a convincing manner, with an expansion in volume. Support Turned Resistance: Once support is broken, it is common for this same support level to turn into resistance. Sometimes, but certainly not always, the price will return to the support break, and offer a second chance to sell. Price Target: After breaking neckline support, the projected price decline is found by measuring the distance from the neckline to the top of the head. This distance is then subtracted from the neckline to reach a price target. Any price target should serve as a rough guide, and other factors should be considered as well. These factors might include previous support levels, Fibonacci retracements, or long-term moving averages.

Technical Analysis: Head-and-Shoulders Bottom

Technical Analysis: Head-and-Shoulders Bottoms
Prior Trend: Without a prior downtrend, there cannot be a Head and Shoulders Bottom formation. Left Shoulder: While in a downtrend, the left shoulder forms a trough that marks a new reaction low in the current trend. After forming this trough, an advance ensues to complete the formation of the left shoulder (1). Head: From the high of the left shoulder, a decline begins that exceeds the previous low and forms the low point of the head. After making a bottom, the high of the subsequent advance forms the second point of the neckline (2). Right Shoulder: The decline from the high of the head (neckline) begins to form the right shoulder. This low is always higher than the head, and it is usually in line with the low of the left shoulder. When the advance from the low of the right shoulder breaks the neckline, the Head and Shoulders Bottom reversal is complete. Neckline: The neckline forms by connecting reaction highs 1 and 2. Reaction High 1 marks the end of the left shoulder and the beginning of the head. Reaction High 2 marks the end of the head and the beginning of the right shoulder. Depending on the relationship between the two reaction highs, the neckline can slope up, slope down, or be horizontal.

Technical Analysis: Head-and-Shoulders Bottoms
Volume: While volume plays an important role in the Head and Shoulders Top, it plays a crucial role in the Head and Shoulders Bottom. Without the proper expansion of volume, the validity of any breakout becomes suspect. Volume on the decline of the left shoulder is usually pretty heavy and selling pressure quite intense. The advance from the low of the head should show an increase in volume Neckline Break: The Head and Shoulders Bottom pattern is not complete, and the downtrend is not reversed until neckline resistance is broken. For a Head and Shoulders Bottom, this must occur in a convincing manner, with an expansion of volume. Resistance Turned Support: Once resistance is broken, it is common for this same resistance level to turn into support. Often, the price will return to the resistance break, and offer a second chance to buy. Price Target: After breaking neckline resistance, the projected advance is found by measuring the distance from the neckline to the bottom of the head. This distance is then added to the neckline to reach a price target. Any price target should serve as a rough guide, and other factors should be considered, as well.

Technical Analysis: Head-and-Shoulders Tops or Bottoms
70-80% reliable in terms of significant move after neckline is broken Time required to complete can be days or up to several weeks Frequently seen in grains and livestock commodities Easy to recognize Low trading volume on each side of the “head” confirms the formation

Market Trend Analyses: Simple Moving Averages (SMA)

Market Trend Analyses: Moving Averages: Trading strategy
Sometimes traders use two moving averages to determine buy and sell decisions. Using a slow moving average (more days) together with a fast moving average (fewer days) generates the following trading strategies: Buy when the faster moving average goes above (crosses) the slower one (from below). Sell when the faster moving average goes below (crosses) the slower one (from above). Buy when prices are above both the fast and slow moving averages. Sell when prices are below both the fast and slow moving averages. As with most tools of technical analysis, moving averages should not be used on their own, but in conjunction with other tools that complement them. Using moving averages to confirm other indicators and analysis can greatly enhance technical analysis.

Market Trend Analyses: Volume and Open Interest
Technical analysts believe that volume and open interest provide information about whether a price move is strong or weak. If prices are rising and open interest and volume are increasing – new money is thought to be flowing in the market, reflecting aggressive new buying – Bullish If prices are rising but volume and open interest are declining – the rally is thought to be caused primarily by short covering – money is leaving rather than entering the market – the uptrend will probably end once the short covering is complete – Bearish. If prices are falling but volume and open interest are rising – new money is thought to be flowing in the market – reflecting aggressive new short selling – the downtrend will probably continue – Bearish If prices are falling and volume and open interest are declining – the price decline is considered to be the result of losing longs liquidating their positions - weak downtrend – the downtrend will probably end soon – Bullish

Lecture 3 Technical Analysis

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