- 1997: Volume 6, No. 5 International Corner: Great Floods Flow From Simple Sources

Editor's Note: In his second article for the CRB Trader (originally published in May 1996), Jonathan Green claims that many of the methods used by the modern day technical analyst are of little use to the trader/investor and demonstrates a simple technique for identifying major and minor trends in today's highly complex financial markets.

According to Robert Edwards and John Magee in their classic book, "Technical Analyses is the science of recording usually in graphic form the actual history of trading in a certain stock or the 'averages,' and then deducing from that pictured history the probable future trend."

Their basic premise is that price action discounts everything and that all there is to be known about any market is already factored into prices. From this formal theoretical base, it is believed that future prices can be predicted with some degree of accuracy. This is the thinking of the technical purist which has come to the fore in recent years and brought with it the models and trading systems which claim to predict, in advance, the extent and duration of future price action.

In my opinion, any attempt to forecast the future through this form of technical analysis is ultimately doomed to failure. In fact, it is this type of crystal ball gazing which is giving this subject such poor press at present.

Indeed, this type of analysis ignores the subjective nature of market activity and thus finds it impossible to calculate market sentiment and the likely direction taken by speculative flows. After all, it is individuals that make up the collective strength of any market and their psychological tendency is the key to their decision making process. Market conditions can and do change rapidly in response to a variety of news and economic statistics with the effect that traders' and investors' attitudes can be altered very quickly. A recent example of this process was seen in the U.S. Treasury market with the release of the unexpectedly high February payroll numbers. This had a profound effect on the psychological tendency of many of the market participants who were still fundamentally bullish up to this point.

Therefore, it would seem extremely difficult for these complex models and trading systems that are so prevalent in the industry today to predict future price trends with any degree of accuracy over the longer-term.

In reality, technical analysis may give indications of possible future price trends, but what it really offers is the opportunity to identify the balance or imbalance between buyers and sellers in any market. You are dealing with the reality of supply and demand as it is expressed through market action. Of course, this is the complete opposite of the fundamental analyst who deals only with projections of supply and demand.

Furthermore, this type of analysis offers the trader or investor a practical approach to help enforce a disciplined trading strategy in a market. No longer can a position be maintained against a stop, which has clearly been broken, in the hope that the market will turn back his way. He is forced to confront reality, rather than an illusion created by his predefined expectations which may have been drawn from his own false conclusions.

Of course, the most important point of identifying the balance or imbalance between buyers and sellers is the determination of the market trend. One of the first maxims a trader or investor learns is that the "trend is your friend." But which trend?

Technical Phases

A market is always in one of three technical phases: it is trending-up making higher highs and higher lows; it is trending-down making lower lows and lower highs; or it is moving sideways either in a distribution phase at the top of a market, or an accumulation phase at the bottom of a market or just plain consolidating after a strong trending move.

In all three of these phases the market is drawing a line-whether it be up, down or sideways. These lines help to form patterns of price action. A good example is a rectangle or triangle. These formations help the technical analyst identify the underlying sentiment of the market.

A triangle or rectangle is usually a form of hesitation or corrective pattern, a resting phase to the major trend and only on the breakout will the major trend continue on its way. So the lines drawn by the market have helped the trader/investor to understand the underlying psychology of the market and observe the beginning of the next impulsive move.

However, the most useful facet for the technician concerned with the market drawing lines is the ability to join specific points along the trend and countertrend movements, and obtain what is called a trendline or the line of the trend.

This simple technique is not oftened mentioned, but is used by the majority of chartists who operate in the sophisticated computer world of the 1990s.

At the stroke of a pen, an accurately drawn trendline on a chart can reveal the status of the major and minor trend. To be useful the trendline must be drawn correctly, and the method I have devised is very simple: First, select the time frame in which you intend to invest or trade, preferably the long-term which must be based on a weekly chart. Then, from the break of the previous trend, draw the trendline from the lowest low or highest high and extend the line through at least two non-recurring hesitations or resting patterns. Finally, look for a break of the trendline and a close above or below it on a weekly basis to reverse the major trend. Also, the trendline importantly provides a running stop which is highly visible to the main trend.

Market Examples

A simple example of the benefit of using this system can be seen from the accompanying charts. Chart 1 shows a weekly continuation chart of U.S. Treasury Bond futures. According to my criteria, the long-term trend turned up on the break and closed above the downtrend line in late November 1994 with a weekly close above 97.30. The subsequent uptrend line then passed through two hesitation patterns, marked A and B. Until this trendline was broken on the weekly close below 118.09 on February 16, 1996, the uptrend remained intact in a very consistent manner. The subsequent sharp move, once the trendline has been broken, confirmed that the major trend had turned downwards and that any long positions were no longer appropriate.

Figure 1

Chart 2 shows a weekly continuation chart of Dollar/Yen for the past four years. It illustrates quite clearly that the major trend was firmly down until the middle of 1995. However, the multi-year decline was interrupted by four hesitation or corrective cycles, and these are marked A, B, C and D. Each one formed a different structure, but they all quite clearly turned the minor trend upwards for some four to five months at any one time. It wasn't until the middle of September 1995 and the weekly close above the downtrend line at 97.40 that the key reversal took place. The immediate acceleration above the down trendline only served to show the significance of this breakout.

Figure 2

Chart 3 shows a daily chart of Dollar/Yen and demonstrates once again how the market is drawing a line, but in the shorter time frame. This reveals that the market is currently in a resting or transition pattern to the major trend, although it is gradually edging higher within an ascending triangular pattern. This is a bullish corrective formation and only a break and close above the upper channel line will signal that the next leg of the impulsive move is underway.

Figure 3

Alternatively a break and close below the lower channel would show that the correction is taking on a more complex form and this would allow longs to adjust their positions accordingly.

Once you become familiar with this method it becomes easy to identify the major and minor trends in a large number of markets extremely quickly. You also have the edge in seeing whether your current positions are with the major trend or against it. The chart and its trendline cannot lie.

Throughout the ages it is often the simple ideas which have stood the test of time and proved to be the most effective. After all, it was William Shakespeare who said, "Great floods have flown from simple sources."

Jonathan Green is a former technical trader with Lazard Brothers in London. In conjunction with running a farming business, he spends his time analyzing and trading a wide variety of financial and agricultural markets-his strategy emphasizes the importance of the long-term approach.