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Stock market trends: the behaviour of a chartist. By Enrico Grassi. The head and shoulders formation can be bullish or bearish, it’s typical formation is the following. Let us examine the bearish formation in detail :

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slide3

The head and shoulders formation can be bullish or bearish, it’s typical formation is the following

slide4

Let us examine the bearish formation in detail:

the neckline may be horizontal as in the figure or ascending / descending, the shoulders may be at the same price level or at different levels, these variations to respect to the typical formation gives the trader additional information as to the degree of probability that the formation will follow up with a break through, i.e. a descending neckline as well as a lower right shoulder raises the probability of a successful pattern formation, on the other hand an ascending neckline as well as a higher right shoulder decreases the probability of a successful formation.

slide5

In his book “ The Psychology of Technical Analysis” Tony Plummer traces a theory that tries to explain the origin of the pattern as a consequence of natural non linear dynamic systems due to the negative feed back loops. The mutual development between a system and the environment involves an interesting and important concept of co-evolution. The first works on the subject are due to Vito Volterra 1926 and continued by Alfred Lotka in 1956, the theory was further developed by biologists Paul Ehrlich and Peter Raven in 1965.

slide6

The market place can be viewed as an eternal battle between to crowds of people: the bullish crowd and the bearish crowd. If the bull crowd is in majority the market is under buying pressure and prices rise, if the bears are in majority the market is under selling pressure and prices decline. The battle between bulls and bears is similar to that of predators and prey in nature. The two crowds participate in a cycle that can be represented as follows:

slide7

The diagram represents a limit cycle and helps us see the relationship between the two crowds in A we have the max of the bull crowd, in B the bull crowd is dropping and the bear crowd is gaining, in C the bear crowd has reached its climax as the bull crowd has reached its min., in D bull crowd is growing again as the bear crowd declines.

slide8

Similar is the diagram between prices and sentiment of the market players.

In A we have high prices and sentiment has still little to grow, In B both prices a sentiment are dropping, in C prices are at a low as sentiment has still some more to go down, in D prices are picking up quickly as sentiment follows.

slide9

This sort of cycle would produce a stabile price oscillation in time, it is the action of shocks to the system which generate the head and shoulder formation. Shocks accelerate the ascending and descending stages, the system reacts to the shocks as to re-establish the main cycle, in the phase diagram spirals are generated ( Plummer assumes golden ratio spirals and so connects the process to Fibonacci series).

slide10

Let us trace the cycle in a price –sentiment frame and see how the head and shoulder formation generates.

slide13

A line chart is the simplest type of chart. One price (typically the close) is plotted for each time period (i.e., day, week, month, etc.). A single, unbroken line connects each of these price points.

slide16

The Japanese developed a method of technical analysis in the 1600s to analyze the price of rice contracts. This technique is called Candlestick charting.

Candlestick charts display the open, high, low, and closing prices in a format similar to a modern-day bar-chart. Articles written by Steven Nison that explain Candlestick charting appeared in the December, 1989 and April, 1990 issues of Futures Magazine. The definitive book on the subject is Japanese Candlestick Charting Techniques also by Steve Nison (see Suggested Reading).

Some investors are attracted to Candlestick charts by their mystique--maybe they are the "long forgotten Asian secret" to investment analysis. Other investors may be turned-off by their mystique. Regardless of your feelings about the mystique of Candlestick charting, we strongly encourage you to explore their use. Candlestick charts dramatically illustrate supply/demand concepts defined by classical technical analysis theories.

slide18

Developed by Richard W. Arms, Jr., and explained in his book Volume Cycles in the Stock Market (see Suggested Reading), Equivolume presents a highly informative picture of market activity for stocks, futures, and indices.

Equivolume departs from other charting methods with its emphasis on volume as an equal partner with price. Instead of being displayed as an "afterthought" on the lower margin of a chart, volume is combined with price in a two-dimensional box. The top line of the box is the high for the period and the bottom line is the low for the period. The width of the box is the unique feature of Equivolume charting; it represents the volume of trading for the period.

The width of the box is controlled by a normalized volume value. The volume for an individual box is normalized by dividing the actual volume for the period by the total of all volume displayed on the chart. Therefore, the width of each Equivolume box is based on a percentage of total volume, with the total of all percentages equaling 100.

slide19

The resulting charts represent an important departure from all other analytical methods, in that time becomes less important than volume in analyzing price moves. It suggests that each movement is a function of the number of shares or contracts changing hands rather than the amount of time elapsed.

Perhaps the Equivolume charting method is best summed up by the developer himself as follows: "If the market wore a wristwatch, it would be divided into shares, not hours."

slide22

Three Line Break charts originate from Japan and were introduced to the western world by Steve Nison (a well-known authority on the Candlestick charting method). The Three Line Break charting method gets its name from the default number of line blocks typically used.

Using the closing price, a new white block is added in a new column if the previous high price is exceeded. A new black block is drawn if the close makes a new low. If there is neither a new high or low, nothing is drawn.

With a default Three Line Break, if a rally is powerful enough to form three consecutive white blocks, then the low of the last three white blocks must be exceeded before a black block is drawn. If a sell-off is powerful enough to form three consecutive black blocks, then the high of the last three black blocks must be exceeded before a white block is drawn.

slide23

To draw line break blocks, today\'s close is compared to the high and low of the previous block. A block is drawn only when today\'s close exceeds the high or low of the previous block. If today\'s close is higher than the top of the previous block, a new white block is drawn in the next column from the prior high to the new high price. If today\'s close is lower than the bottom of the previous block, a new black block is drawn in the next column from the prior low to the new low price. If the close fails to move outside the range of the previous blocks high or low, then nothing is drawn.

With the default Three Line Break chart, a downside reversal (i.e., white blocks change to black blocks) occurs when the price moves under the lowest price of the last three consecutive white blocks. A black reversal block is drawn from the bottom of the highest white block to the new price. An upside reversal (i.e., black blocks change to white blocks) occurs when the price moves above the highest price of the last three consecutive black blocks. A white reversal block is drawn from the top of the lowest black block to the new high price.

slide25

Kagi charts are thought to have been created around the time the Japanese stock market started trading in the 1870s. Kagi charts were introduced to the western world by Steve Nison (a well-known authority on the Candlestick charting method). Kagi charts display a series of connecting vertical lines where the thickness and direction of the lines are dependent on the price action. If closing prices continue to move in the direction of the prior vertical Kagi line, that line is extended. However, if the closing price reverses by a pre-determined "reversal" amount, a new Kagi line is drawn in the next column in the opposite direction. An interesting aspect of the Kagi chart is that when closing prices penetrate the prior column\'s high or low, the thickness of the Kagi line changes.

slide26

To draw Kagi lines, compare the close to the ending point of the last Kagi line. If the price continues in the same direction as the prior line, the line is extended in the same direction, no matter how small the move. However, if the closing price moves in the opposite direction by the reversal amount or more (this could take a number of sessions), then a short horizontal line is drawn to the next column and a vertical line is continued to the new closing price. If the closing price moves in the opposite direction of the current column by less than the reversal amount then no lines are drawn.

In addition, if a thin Kagi line exceeds the prior high point (on the Kagi chart), the line becomes thick. Likewise, if a thick Kagi line breaks a prior low point, the line becomes thin.

slide28

The Renko charting method is thought to have acquired its name from "renga" which is the Japanese word for bricks. Renko charts were introduced by Steve Nison (a well-known authority on the Candlestick charting method).

Renko charts are similar to Three Line Break charts except that in a Renko chart, a line (or brick as they are sometimes called) is drawn in the direction of the prior move only if a fixed amount (i.e., the box size) has been exceeded. The bricks are always equal in size. For example, in a five unit Renko chart, a 20 point rally is displayed as four equally sized, five unit high Renko bricks

slide29

To draw Renko bricks, today\'s close is compared with the high and low of the previous brick (white or black). When the closing price rises above the top of the previous brick by the box size or more, one or more equal height, white bricks are drawn in the next column. If the closing price falls below the bottom of the previous brick by the box size or more, one or more equal height, black bricks are drawn in the next column.

If the market moves up more than the amount required to draw one brick, but less than the amount required to draw two bricks, only one brick is drawn. For example, in a two unit Renko chart, if the base price is 100 and the market moves to 103, then one white brick is drawn from the base price of 100 to 102. The rest of the move--from 102 to 103--is not shown on the Renko chart. The same rule applies anytime the price does not fall on a box size divisor.

slide31

Point & figure (P&F) charts differ from "normal" price charts in that they completely disregard the passage of time and only chart changes in prices. Rather than having price on the y-axis and time on the x-axis, P&F charts display price changes on both axes.

P&F charts display an "X" when prices rise by the "box size" and display an "O" when prices fall by the box size. Note that no Xs or Os are drawn if prices rise or fall by an amount that is less than the box size.

Each column can contain either Xs or Os, but never both. In order to change columns (e.g., from an X column to an O column), prices must reverse by the "reversal amount" multiplied by the box size. For example, if the box size is 3 points and the reversal amount is 2 boxes, then prices must reverse direction 6 points (3 times 2) in order to change columns. If you are in a column of Xs, the price must fall 6 points in order to change to a column of Os. If you are in a column of Os, the price must rise 6 points in order to change to a column of Xs. The changing of columns signifies a change in the trend of prices.

slide32

Because prices must reverse direction by the reversal amount, each column in a P&F chart will have at least "reversal amount" boxes.

When in a column of Xs or Os, MetaStock will first check to see if prices have moved in the current direction (e.g., rose if in a column of Xs or fell if in a column of Os) before checking for a reversal. MetaStock uses the high and low prices to decide if prices have changed enough to display a new box.

slide35

Conclusion:

Charting techniques help the trader visualize promising patterns. Chart analysis is part of technical analysis, technical analysis is not the only way to go, a trader should in my view also do some fundamental analysis and protect his money with a sound money management technique.

The head and shoulders formation is very common and in this paper I have tried to give it a sound natural basis.

slide36

References:

  • G. Le Bon,Psicologia delle folle ,Longanesi&C.,Milano1980
  • T. Plummer, The psychology of technical analysis, Probus Publishing Company, Chicago,1990
  • M.J. Pring, Investment psychology explained, John Wiley & Sons, Inc., New York, 1993
  • M.J.Pring, Pring on market momentum, International Institute for Economic Research, Inc., Gloucester, 1993
  • M.J. Pring, Analisi tecnica dei mercati finanziari, Mcgraw-Hill,Milano,1989
  • E. Coliva, L. Galati, Analisi tecnica e finanziaria, Utet, Torino,1992
  • A. Fornasini, Analisi tecnica e fondamentale di borsa, Etas Libri, Milano,1991
  • A. Fornasini, A. Bertotti, Analisi tecnica dei mercati finanziari, Etas, Milano,1992
  • J.E. Murphy, Jr., Stock market probability, Probus Publishing Company, Chicago,1991
  • J.J.Murphy, Technical analysis of the futures markets, New York Institute of Finance, New York,1986
  • F.E. Cirio, Guida pratica ai futures su indici azionari, Il sole 24ore libri, Milano,1992
  • S. Nison, Japanese candlstick charting techniques, New York Institute of Finance, New York,1991
  • S. Nison, Beyond candlesticks, John Wiley & Sons, Inc., New York, 1994
  • R.W. Arms, Jr., Volume cycles in the stock market, Equis International, Inc.,U.S.A., 1994
  • L.G. McMillan, Options as a Strategic Investment, New York Institute of Finance, New York,1993
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