- 1999: Volume 8, No. 6 A Synergistic Approach to Technical Analysis

Prices do either one of two things: they move sideways or they trend. Determining accurately which of these the market is doing at any particular point in time is perhaps the most important part of technical analysis. This may seem very simple, however, there are major trends and minor trends and in the example that follows we have a minor downtrend within a major uptrend. Once the trend of the market, or lack thereof, is determined there are countless technical indicators that can be employed to pinpoint the minor turning points within the trend, to extrapolate how far and how long the trend will continue, to measure the strength of the trend at any given time, and finally to decide when the trend no longer exists. A brief discussion of the application of the basic tools of technical analysis, using D-marks as our example, should prove helpful.

Volume and Open Interest

Along with price, volume and open interest are two other sources of technical information which often either directly or indirectly become key points of study for technical analysis. Let's look at them individually.

Volume is the total number of contracts traded during a given trading session and is usually recorded by a vertical bar, known as a histogram, directly below that day's price bar. Each unit of volume signifies the "trade" of one contract and includes both buyer and seller. Volume measures the urgency that the market participants feel to trade on a given day. In a "healthy" trending market, volume should increase as the market moves in the direction of the trend and decrease during counter-trend moves (see V1and V2 in Figure 1).

Open interest is the total number of unclosed or "open" trades at the end of each trading session. A histogram of open interest appears on the lower chart. Like volume, each unit of open interest represents one trade and includes both buyer and seller. Open interest shows the number of contracts that the participants feel confident to "take home overnight." While rising volume signals urgency, rising open interest demonstrates conviction that the market will continue in its current direction. Lack of conviction is demonstrated when open interest remains "flat" or diminishes slightly during countertrend moves (O1/O3). Open interest will often warn of an impending change in market direction several days before it occurs by stalling in its expansion and/or beginning to diminish as in O2. This illustrates that the "smart money" which has been long for a good part of the move is starting to quietly take profits.

In short, volume and open interest give us a look beyond price into what the market is actually "thinking."

Trendlines

Extremely flat, horizontal trendlines and very steep vertical trendlines are usually less effective and useful than trendlines that maintain a 45 degree angle. The longer a trendline remains in effect without being penetrated, the more valid it becomes. Also, the more "time" (distance) separating the first two points of the trendline, the stronger and more useful it becomes. Valid penetration of a trendline occurs when the market closes through it for two consecutive trading sessions. Note point C where the market closed below uptrend line AB once, but then rallied back above it the very next day on expanding open interest. This is a bullish technical signal and suggests that a new "up leg" is now underway.

Chart Patterns

A small Double Bottom pattern (D1 & D3) appears on the chart below point D which defined a major low in the market. Note that a low was made at the very beginning of June, after which the market rallied to a minor high (point D2) two days later only to retest that low several days later. Once the market successfully held the early June low the second time and rallied and closed above point D2, a Double Bottom pattern was validated. An upside target can now be derived from this chart pattern by first drawing a horizontal line across both lows and taking a vertical measurement from the line to the high of day D2. The measurement can now be extended upward from point D2 to give us a minimum upside target of about 0.6025. As you can see, this upside target was met and exceeded very quickly.

Moving Averages

The 5-day and 20-day moving averages are overlayed on the chart. The upward cross of the 5-20 day moving averages at point E defined the beginning of a new uptrend. The downward cross of these averages at point F marked a temporary interruption in the uptrend, while the subsequent upward cross at point G signaled the resumption of the uptrend.

Overbought/ Oversold (RSI Stochastic)

Overbought/oversold indicators, also known as oscillators, define areas in the market where a temporary change in market direction may take place. Since the markets do not move straight up and straight down, using overbought/oversold indicators such as the Relative Strength Index (RSI) can help to define potential turning points in price by measuring the internal strength of a given market. Notice the horizontal lines in the RSI chart at 30 and 70. They signify overbought (70) and oversold (30) zones.

When the RSI rises above 70 the market is becoming technically overbought and susceptible to a sell off, and conversely an RSI reading below 30 signifies an oversold situation and warns of an impending bullish reversal. Note the low in the RSI and in the price made around the beginning of June at point J. In this particular case the RSI never quite made it into oversold territory below 30, but reversed and moved higher just above 30. When a reversal in RSI occurs prior to it reaching an oversold condition, this is often a sign of strength in the market as you can see by the subsequent major rally in price.

Now let's move ahead on the chart to points X and Y located on both the price and RSI charts. At point X, price was making higher highs while the RSI was rising into overbought territory around 85. This overbought condition in the RSI preceded a minor dip in price, after which price made a higher high while the RSI was able to rally back into overbought territory. But unlike price, the RSI was unable to make a higher high, creating bearish divergence. Bearish divergence will often directly precede a significant drop in price as was the case here as the market quickly declined to point K. The corresponding Point K on the RSI is very similar to Point J discussed a bit earlier in that the RSI was unable to drop into oversold territory before reversing and turning higher. This is a sign of technical strength that was quickly reflected in the upward surge in price from Point K.

Now that we've learned some basic technical tools, let's look at the chart as a case study and learn how we might combine these indicators to formulate an opinion and a strategy.

First at point D3 we notice that the market has attempted and failed to trade below point D1, and then it begins to rally.

We wait for the market to close above point D2. At point E, we observe that a double bottom has been formed with a minimum upside objective of .6010. We also notice that the 5- and 20-day moving averages cross higher while the RSI begins to reverse and move upward, confirming the buy signal in the double bottom. We may elect to buy the market now while placing a Sell Stop order to limit our risk just below the recently made lows at D3 (5860).

If we are more conservative, we may wait for the increase in open interest seen around the beginning of July to confirm the move higher, or if we are already long this might be a good area to add to the position.

Around the first week of July, we notice that the market is becoming short term overbought according to the RSI so we begin to adopt a defensive attitude. However, after a small sell-off the market is able to hold the 20-day moving average as support and after a brief decline, open interest starts to expand once again to confirm the new move into higher ground.

The next move higher evokes an overbought RSI situation so we once again become defensive about our currently profitable long position. However, neither the major uptrend line or 20-day moving average is penetrated to the downside by price as the RSI declines once again, so we maintain our long position. This time, however, a new high in price is made but not so in the RSI, creating bearish divergence. At the same time we also notice that since the first of August open interest has peaked and is now on the decline (O3). This suggests that the profitable longs are starting to take profits and is another very good reason to look for an impending sell-off.

We now begin to look for a spot to place a protective sell stop in order to lock in the profits that we've accrued thus far. Therefore, we look for support underneath the market in the form of its 20-day moving average. The 20-day moving average is penetrated to the downside at almost the same time as the 5-day moving average breaks below it (E). This is yet another bearish signal so we immediately sell out our long position and take a nice profit.

The market breaks down a bit further but stops at point K. The market begins to rally and soon the 5- and 20-day moving averages cross to the upside once again, a buy signal. This is a good area (G) to reestablish our long position with a protective sell stop just below the low made at Point K. Open interest begins to expand approximately two weeks later to confirm the move higher. This is a good place to add to the new long position, or for more conservative traders, a prudent level to reestablish our long position.

Open interest begins to plateau in mid-October and warns of the sell-off that occurs shortly thereafter in approximately the third week of October. The RSI rises above and then declines below the 70 area to help confirm the likelihood of a sell-off occurring soon.

The sell-off does in fact occur as expected around the beginning of November. However, this decline in price does not penetrate any significant levels of underlying support such as the 20-day moving average or the major uptrend line, nor do the 5- and 20-day moving averages cross to the downside. Therefore, we maintain our long position and the market continues to rally into mid-November on expanding open interest to confirm the move higher. We are now the proud owners of a very nicely profitable trade that has been objectively thought out and prudently executed.

Around the third and fourth week of November three important things occur. Number one, the overbought RSI descends out of overbought territory, a bearish warning signal. Number two, open interest diminishes drastically, suggesting that profitable longs are taking their profits. Number three, price moves below the 20-day moving average while the 5- and 20-day moving averages cross to the downside. This is enough bearish information to convince us that a sell-off is in fact underway and we exit our long position immediately, taking a very nice profit near the end of November.

However, traders with a bit more risk tolerance might want to be sure that the previously strong uptrend is definitely over by electing to stay long until the major uptrend line is penetrated to the downside by two closes below it. At point C one close below the major uptrend does in fact occur, but the market quickly recovers by trading back above this major uptrend line while being confirmed by a) expanding open interest and b) a bottoming/rising RSI.

This case study of technical analysis is an attempt to tie all of the above-mentioned tools together into an informed, logical and intelligent approach to trading the markets. Like most things in life, the more time you devote to technical analysis the better and more insightful you will become. Using technical analysis we are able to best consider all outside factors that affect price action and make a well-informed determination of its future direction.

John J. Kosar, CMT is a Chartered Market Analyst and Technical Analyst for BridgeNews in Chicago.