- 2000: Volume 9, No. 6 Chartist Corner: Trend Breaks in Studies

In the past, Chartist Corner has explored the building blocks of analysis. In this edition, we'll apply some of the techniques learned to studies to find advance warning of market changes.

Technical trends and trend breaks are commonly used techniques for analyzing bar charts. They are also valid for analyzing momentum indicators such as Relative Strength and can provide information as to the internal strength in the market. As we discussed in our January/February 1999 edition (Divergence), indicators can move in one direction while the price action they are following is moving in the other direction. For example, Stochastics can be falling while prices are rising. This indicates that the internal structure of the market is weakening and prices are likely to stop rising, if not starting to fall.

The same type of information can be found in the trend of the study. In the above example, the Stochastics could have been trending higher with price, making higher highs and higher lows. Divergence occurs when the study makes a lower high as price continues to make a higher high. A trend break occurs when the study makes a lower low as price continues to make higher lows.

Figure 1:

Figure 2:

Figure 1 shows the S&P 500 Cash Index for the past 11 months. The trendline for the rally beginning in June 1994 was broken on 20 September but the 14-day RSI and the 14-day Slow Stochastics studies both broke their trendlines nearly two weeks earlier. This information should not trigger an immediate sell of the S&P 500 but it allows the trader to position himself for a likely sell-off.

As of this writing, the same situation is developing for the rally that began in December 1994. In this case, the studies are showing both divergence and trend breaks, providing an ominous signal for US stocks. Figure 2 shows a similar but longer term situation for the Australian stock market (All Ordinaries). In addition to the other studies mentioned, the MACD had shown a trend break several days before the break out in prices.

The use of this technique must be adapted to the market as the stock market in general gives good signals while other markets, such as gold and currencies, do not always give such advance warning.

Figure 3:

As with most technical indicators, this technique works in all time frames. Figure 3 shows a weekly chart for the Nikkei 225 Index. Both RSI and MACD provided warning more than six months earlier that the long slide in Japanese stock prices was nearing an end, at least temporarily.

In summary, when momentum indicators show technical reversal patterns, it can mean that prices will soon follow suit. The trend breaks in studies seen here all occurred at or just after market peaks or bottoms. While aggressive traders may initiate trades at these times, it is more prudent to wait for the confirmation of a break in price trend.

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.