- 1999: Volume 8, No. 3 Chartist Corner: Bollinger Bands

Technical Analysis has many objective rules and techniques but it all still depends on the subjective interpretations of the analyst. For example, after a market establishes a support level it trades one or two ticks below it. Is that considered to be a break of support? What if it traded below support for only a brief time and then bounced right back up? The analyst must use other indicators and rely upon his experience to determine if this was a real signal or just market "noise."

The General Rule

If support and resistance lines contain a trading range then trendlines are simply support and resistance lines that contain a market move. If the market is falling, then the resisting trendline (the one on top) should stop any rallies going against the primary trend lower.

In figure 1, the peak in the continuous IMM Canadian Dollar future (200 weeks) was set in late 1991. The top of the bar for that week serves as the start point for the trendline. As the market trades lower, some market participants will eventually decide that it has become undervalued (cheap). They begin to buy, causing the market to trade a little higher (retracement). This counter-trend rally eventually loses its power as everyone who was going to buy has already done so. The sellers once again take control and the market resumes its decline. Those recent buyers also reverse their positions, seeing that they were wrong, and add to the selling pressure.

Figure 1

This sort of trading action is exactly what happens at a resistance level. Since a declining trendline provides resistance, it should then be drawn from the recent high, which was set in late 1991 in figure 1, to the high of the retracement rally, which was in early August 1992. The trendline is extended lower as time goes on. As can be seen in the chart, this trendline has resisted all counter trend rallies up until the end of the chart. Just as with support and resistance levels, the more times the market touches them, the stronger they become. Further, the stronger the trendline, the more significant the signal when the market penetrates it.

All of this leads to the famous expression "the trend is your friend." Once a trend is established, the trader buys or sells accordingly. He does not take the opposite side of these trades until the market tells him to do so, i.e. the trend is broken.

Major and Minor Trends

Within any trending market, there are counter trends and within these counter trends there are even smaller ups and downs. This is how a market, such as stocks, can be in a bull market for twelve years and still suffer the counter trend decline of October 1987. For those who remember, even during that huge one day drop, the market staged an impressive counter trend rally near the close of the European trading day.

At the point the Canadian Dollar met the resisting trendline in August 1992, it began a steep four month drop. A shorter term trend line could be drawn from that peak until the top of the first counter trend rally in October 1992. Since the market only touched this trendline a few times, the trend break that happened in December proved to be only strong enough to bring the market back to its longer term trendline.

Technician's License

The markets usually don't provide as nice an example as the Canadian Dollar did. Sometimes, the first trendline is set and then repositioned later as the market continues its move. Sometimes, the market breaks through a trendline, only to trade back as if nothing had happened. Remember, the market does not follow what the analyst says it will do. Rather, the analyst attempts to put down on paper (or screen) what the market is telling him. Sometimes, his interpretation is based on incomplete information and he must reserve the option to modify any rules he sets up. Again, they are the analyst's rules, not the market's.

In figure 2, the March 1994 Canadian Dollar contract (seen in a 30 minute bar for 23 days) began a decline on 27 January. Its first counter trend rally appeared to end on 3 February and the trendline would have been drawn through that peak. However, the next day, the market briefly traded above the trendline before declining again. The trendline must now be moved to the second peak. Any trader who bought the Canadian Dollar based on the trend break needed to reverse the position, and claim a small loss, immediately after the market dropped below the trendline.

Figure 2

Several days later, the market once again appeared to break the trendline and once again, it fell back below it. The aggressive trader would ignore the trend break and keep the trendline drawn through the first retracement peak (3 February). The more conservative trader would move the trendline to accommodate the new information. What this does is allow the aggressive trader to buy on a trendbreak before the conservative trader. The profit potential is larger but so is the risk of being fooled again by a false breakout.

Any market will present these opportunities for both kinds of traders. Each tries to fit the trendline to the data in a way that makes sense to him and each needs to be disciplined enough to take a small loss when he is wrong.

Michael N. Kahn is a columnist for Barron's Online based out of Florida. He also writes a free technical newsletter. To subscribe to this service, please visit www.midnighttrader.com. The complete collection of Michael Kahn's "Tips on Technicals" is available in Real World Technical Analysis.