Archive for Chart Reading
It is not that complex.
Just spike and ledge on weekly.
Mission accomplished today.
Daily chart on crude.
I marked the first quarter STOPD Levels.
If there is a 3rd push back up, it will be back up to 107-107.5 where the 1st quarter low is.
It is not a long term bullish play.
Instead, this 3rd push up is a short term counter-trend swing play.
Spike and ledge first target reached.
As long as the baseline of the spike and ledge acts as resistance, the next target below is in play.
The chart of Nasdaq Composite below.
If this is the anti-crash climax following power law distribution like what happened to Nikkei many years ago, not only the crash low will be retested, it will be also take as long as the time it spent on this recovery to find a new base to bottom out.
We are talking about 1 to 2 years of melt down and then followed by 10 years to find a bottom.
It is not something central bankers or governments can do to change this outcome. The more they try to nudge the markets around the world to avoid it, the worse it will become.
Part of Art of Chart Reading
Traders often focus on how accurate certain chart patterns are and how much money you can make from using the patterns. The more experienced ones would add to their consideration of the risk reward profile of the patterns they choose to use. However, many traders never plan to react to situations where their patterns failed to produce the expected outcome. It is one of the harder aspect in chart reading that many traders failed to master because it goes against human nature to plan and act on interruption of expected sequence of outcomes that are completely opposite to the original expectations.
False Breakout Definition
Part of Art of Chart Reading
I started my chart reading education with the swing trend definition because that was the one that my mentors use. It works great back then and works even better nowadays. I have tested many trend definition methods in historical data and none of them really doing better than the plain old simple swing trend method.
It can be puzzling why this simple concept works so well yet people keep looking for better trend identification method.
So why do people keep trying to better the swing trend method?
The answer is obvious. People want to get in earlier, with better entry price, and also exit earlier, with better exit price. The exit price part, as far as I know, it is possible with good understanding of price dynamics. The entry part, however, has a fundamental problem.
Just step back and think logically, a swing extreme is not a swing extreme yet if price has not reacted to the price level. A retracement has to happen first for a period of time to confirm the swing extreme is in place. This confirmative movement is required for any trend identification method to work.
Trend by definition is a confirmative concept because you need at least a few bars of price movements going in a direction to establish a trend. Any attempt to guess if a trend will change is not trend identification. They are called trend prediction. Trend prediction can work but most of the time it requires information outside of price data to improve the accuracy of the predictive method.
A lot of people thought they are creating new price trend identification methods but in fact they are making the mistake of mixing trend identification and trend prediction together. Once their work has moved into the realm of predictive methods, the results become inconsistent and less reliable in general.
There is only so much price data can offer for trend identification. It is important to accept what trend is and use it with the understanding of its limitations including the unavoidable delayed confirmation property.
A Different Way In Looking At Swing Extremes
Now, the more puzzling issue is why swing trend works so well all along?
I can try to explain this without digging into my STOPD theory. Using simple mass psychology may be sufficient. In short, it is all about expectation (or greed) and disappointment (or fear).
Once a swing high is in place, you know a particular price stopped the upward movement of the market. But so do all the other people who monitor the same market. Many of these people are still holding onto their long positions (i.e. those who bought something in the process). They have a goal to make money just like you. This particular price has set the expectation for them. They want to get at least that price (or very close to it) because it was printed. Hence, the potential anxiety and emotional swings heighten as the price approaches that swing high again. Hence the increase in trading activities around these swing highs.
A swing high also created expectation for potential buyers thinking that this swing high is not only possible but also the potential of even higher prices. If enough potential buyers are interested (or lured), higher low in price will be made because of these potential buyers jumping in and absorb the selling. Through this process, an up trend is created.
This psychological effect works similarly with swing lows, although there is a subtle difference in the emotion they can trigger.
Once a swing low is printed, stake holders (those who already bought something) feel relieved. They have this sudden happiness (or high?!) that their money is safe for now.
What if this price is revisited again?
Disappointment, or fear, would kick in for some of these stake holders. Depending on the number of these players, and their personal tolerance of pain, some of them would give up their positions. Thus a sell wave is created, and voila, you get a lower low. If this process continues, a down trend is created.
For Every Contract Bought It Was Sold By Someone Else
In the section above I have only looked at the buy side of the market. It is now time to look at the opposite side of the market.
The sell side of the situations mentioned in previous section would experience the opposite emotions.
When the market has printed a swing high, the short sellers would experience the relief feeling. Then if the swing high is challenged again, fear would easily kick in and induce panic short covering.
When the market made a swing low, the potential short sellers would see this as the possible target. Greed kicks in and driving them to jump in shorting the market. Given enough people selling into the market, both short sellers and those who are giving up their long positions, will pressure the price back down to the swing low.
Breaking Of Swing Trend Is The Deciding Factor
In another words, the price extremes by themselves are the drivers controlling emotions of many market participants. It is also the primary reason why so called fundamental factors of a market does not really matter. A simple example is sufficient to explain why fundamental factors are useless in projecting price movements.
Let’s consider a company that is profitable with good management and no foreseeable change in its presence within its own industry. As its stock price keeps dropping, and that people keep buying the lower prices in anticipation of price recovery to better price level, the price can continue going lower for years.
As long as there is not enough capital flowing into the stock to accumulate at higher prices, the down trend will continue. The bottom pickers who are under margin will be forced to unload their long positions along the way. They have no choice but to sell. Fundamental factors cannot tell the world to push the price higher. It is a good reason but not enough to drive price higher.
When the particular market successfully printed a weekly swing high breaking the down trend, however, the psychology of the market participants will change. They will not feel as pressured or stressed to sell any more. Short term speculators will find this particular company may worth their time, and money, to bet on potential higher prices. The willingness to buy at higher prices by the market participants kick starts the price recovery that the bottom pickers hoped for.
Those who are not affected emotionally by the price extremes, can often take advantage of the crowd psychology and control short term price movements given enough capital is available. You cannot corner a market by buying everything available at a lower price. You can only corner a market by buying aggressively at a higher price. The breaking of the down trend is the key to rally the market participants to swing from feeling bearish to feeling bullish.
You need someone else to buy higher so that you can sell your holdings at a higher price.
Many traders do not understand that this psychological behaviour related to price extremes is more fundamental than just our fear and greed. Our reaction to price extremes are actually part of human nature.
Our brains are built with vision processing that identifies sharp angles much faster than things that are not. It is a necessity for us to survive in the animal kingdom. Emotions are triggered when we see sharp objects moving closer and moving away from us. It is normal.
The unlucky translation of recognizing the price spikes into emotions is just an extension of this hardwired function in our brain. Thus, swing extremes are natural features we tend to recognize and react to. It is not like we have a choice not to do so. What we can choose to do, however, is to use logical reasoning and trained response in chart reading to override our natural reactions to these price extremes.
Of course it is difficult to suppress our emotional reactions to these swing extremes. It is difficult not just because our brains function that way. It is also because of our money is on the line.
The more you are affected by your emotions, the worse your trading decision making will become.
Part of Art of Chart Reading
The basic types of price movements are just contraction and expansion. It is similar to how we breathe. It cannot be simpler.
Contraction Is Decision Time
Contraction is price movement trapped with limited swiftness. It happens when there is temporary equilibrium of committed buying and selling. This temporary condition does not last. As time progresses onward, the opinions of the existing position holders and potential speculators from the sideline will change.
The concentrated position building and money management adjustments within the contraction period will ignite the next round of expansion which may or may not be in the same direction of the previous expansion period.
Expansion Is Action Time
Expansion is price movement that moves away from the contraction period range coverage with increased volatility. It happens when one side of the game is cornered, or when opinions changed drastically in favour of one side. The expansion will come to a stop naturally when the imbalance of buying and selling subsided.
In another words, expansion is the direct result of the aggregated decisions made by the market participants. Once put into motion, the expansion period has limited number of ways to unfold with predictable outcomes.
Transition From Contraction To Expansion
Transition from contraction to expansion is the basic trading opportunity for chart traders. It provides a controlled environment for the traders with reasonably limited number of outcomes to handle. There are of course other trading opportunities in the market. However, these other trading conditions are more complex to analyze and often associated with higher risk.
Transition From Expansion To Contraction
There is also the state of transition from expansion to contraction. It is the most difficult period to trade because the winning side has not emerged yet. Hence there is no price patterns to lean on for the start of the contraction.
For example, a market can be expanding to the up side (i.e. price going higher) and showing signs that the speed of rising is slowing down. It does not, however, automatically translate into the start of a contraction period. The slow down can take some time before the expansion is over.
Chart Patterns Are Just Combinations Of This Breathing Rhythm
Various chart patterns are all recognitions of the recurring behaviour of contraction, expansion, or a combination of both. Not all chart patterns are useful. In fact, many combinations of expansion and contraction do not give you actionable patterns.
The criteria for actionable patterns is quite simple. As a trader, we want to enter a trade in a boxed situation. That means we would like to go into a position with as much confidence as possible on how likely the preferred outcomes will happen. We would also like to control the risk that we are taking to be as well defined as possible. This strategic advantage traders seeking for, greatly reduces the number of patterns from the chart to be tradable.
Hence a good trader is also a boring trader. A trader should spend most of the time monitoring the markets for the best scenarios to present themselves and managing existing positions. Only when the market is doing something recognizable to the trader that are turning into actionable patterns, would the trader jump into action.
Part of Art of Chart Reading
There are many trend identification methods other than swing trend. The number of trend definitions exploded in the late 1990s as that was the time where every person with a personal computer can play with historical price data and trying out new ideas. I am going to mention two well known ones here.
Moving Average Trend
Moving average based trend definition was big back in the 1970s and 1980s. It was the new game in town so to speak. It worked very well and still doing pretty good in some markets like forex even now.
Moving average trend is defined by its direction and its relationship with the price. If the moving average of the price is going up and the price is trading above it, you have an up trend. When price is trading below the moving average and that the moving average is going down, you have a down trend. Anything in between is in no trend.
The reason it was made popular was that computers were very slow in comparison to what we have today. Moving average is very simple to calculate thus faster to get results from the computers. Many variations on this trend definition was created because you can choose what kinds of moving averages and the related parameters you want.
In fact, any combination of moving average settings you want can be used to justify your personal subjective bias. That’s why it was so popular – way too many firms like the idea that they can justify their market calls by throwing in some techno mumbo jumbo that sounds sophisticated.
Moving average based trend identification actually works quite well if it is in sync with the dominating cycle in the underlying instrument. The problem, however, is that dominating cycle in a market changes over time due to many reasons. Hence the approach has all kinds of issues requiring the use of extra confirmative techniques to improve its accuracy.
Linear Regression Trend
Linear regression based trend definition came into play after the moving average craze no longer giving a buzz in the media. It was introduced by engineers interested in financial markets at the time who think the markets behave like particles or waves in physics. Public at the time thought that if a scientific method is applied to something it must be good.
Linear regression method mainly defines a trend by its slope over a predetermined duration or sample points. If the slope of the linear regression line is sloping within certain positive range, it is in an up trend. When the slope of the regression line is sloping negatively within certain range, it is in a down trend.
Linear regression is still used by many long term funds and academics in their research papers. Summarizing the transactions in a market with an arbitrary duration and classifying them with user chosen parameters do not produce sensible information. It produces what you think is relevant. Worst yet, if you use historical data to fine-tune the trend definition, you get curve-fitting results that is of no use in the future.
Similar to moving average trend, linear regression trend has limited success in producing useful information for decision making. Although it is way more tedious in processing the price data, the trend identified from linear regression method is no better than other methods like the moving average method.
Most of the time, even in production trading models used by big hedge funds, the use of linear regression trend does not improve those models at all. I have seen enough chief researcher / system developer with advanced scientific background who believe so much in the method that I know nothing I say will change their minds.
A side-effect from this religious belief among these individuals and other traders has made linear regression trend a self fulfilling prophecy. Just like moving average trend, due to the popularity among traders using them as their decision making tools, the price movements in many markets have shown better responses with the most common settings for these trend identification methods.
Part of Art of Chart Reading
The concept of trend has be a very controversial topic for years ever since the first generation technical traders from early 1900s introduced the idea. I will present the one that I was taught and how to utilize the concept.
Swing Trend Definition
There are many ways to define trend. In general when we read a chart we can classify a part of the chart as up trend, down trend, or no trend. The idea behind the classification is to simplify our decision making process into something more manageable.
Using swing extremes (swing highs and swing lows) as the basis to define trend is called swing trend.
You need at least 2 swing highs and 2 swing lows to form a trend.
An up trend is a series of swing highs and swing lows in 2 increasing sequences, higher swing highs with higher swing lows.
A down trend is series of swing highs and swing lows in 2 decreasing sequences, lower swing highs with lower swing lows.
When the swing highs and swing lows are not either in an up trend or down trend, it is then recognized as no trend.
Example Of An Up Trend
Following is the same chart I used in the Swing Highs And Swing Lows chapter, except that it is in 4 hours timeframe.
Starting from the left most swing low (blue up arrow), this market is clearly in an up trend.
First, the swing highs (red down arrow) starting from the second one to the left has been in an increasing sequence.
Second, the swing lows (blue up arrow) are in an increasing sequence as well.
That makes this part of the chart in an up trend within the 4 hour timeframe.
Trend Exists In The Mind Of The Beholder Only
I am going to compare the above chart against the original one that is in 1 hour timeframe here.
Covering the same period of time with higher resolution, this chart is telling us quite a different story.
As oppose to have one single up trend, the above chart is made up of 3 separate up trend periods. The higher resolution enables us to see quite a number of extra swings in the chart. By comparing the 2 charts, notice how the 1 hour chart here giving us 1 short period of down trend (near the Dec 12 vertical line) and 1 short period of no trend (#1 to #4), while in the higher timeframe (i.e. 4 hour chart) the details are hidden from us.
So when two traders talking to each other argue if a market is in an up trend or not, the point is moot if they have not clearly stated the timeframes and trend definitions they are using. There is absolutely no meaning with the discussion if they are not talking about the same thing. They can be using completely different methods to define the trend. They may also be talking about completely different timeframes, like a 15-minute chart vs. the daily chart. How silly it is we see so many people making this kind of time wasting arguments all the time in public forums and mainstream media.
Unlike economics, once the rules and timeframe are agreed upon, there is no argument of what trend the market is in. The reason is that there is no assumptions involved. As long as the historical data is accurate, the charts would be the same. So given the rules are agreed upon, the conclusions are objective and easy to follow.
Importance Of Trend Identification
A trend classification method serves 2 purposes:
1. provide useful biases in price behaviour
2. provide clean structure for chart pattern definitions
With swing trend method, both #1 and #2 are satisfied.
The biases provided by swing trend across all markets I have backtested in almost all timeframes:
a. When a market is in an up trend, it is more likely that higher swing low would be made.
b. When a market is in a down trend, it is more likely that lower swing high would be made.
c. The biases from a and b declines in probability, after the 4th swing high (or swing low) is in place, at exponential rate.
For usage of trends in chart patterns, it will be discussed in chapters on chart patterns.
Part of Art of Chart Reading
The terms swing high and swing low often show up in all kinds of technical analysis discussions. They are simply the local extremes that are visible to us in a particular timeframe. It is not difficult at all to recognize them visually. They are essential concepts when we are reading the charts.
Defining The Extremes
Following is a chart of 1 Hour British Pound US Dollar.
Visually, it is quite obvious where many of the swing highs (marked by red down arrow) and swing lows (blue up arrow) are. However, if we do not have clearly stated rules to follow, it is difficult to label some of the swing points marked above. Without exact definition, it will be difficult to conduct proper research and historical testing on the concept.
Ever since people started to computerize charts, they worked rigorously on how swing extremes can be defined.
The standard approach to define swing extremes is to compare that against certain number of bars near the extreme.
1. A swing high should be higher than the high of the nearest N bars to both the left and the right side.
2. A swing low should be lower than the low of the nearest N bars to both the left and the right side.
Common choices for N are 3, 4, 5, 8, 20, etc.
This approach to define swing highs and swing lows works most of the time. The exceptional cases are the situations where the market is swinging very quickly. In those situations, as using number of bars to identify swing points is equivalent to counting the amount of time (or number of transactions if you use volume or tick bars), you would miss many important swing points from your chart.
In the example above, if we use the definition of 4 bars minimum for the swings, swing low (#2) will be missed. But visually we know it is an important swing point.
So how do we resolve this issue?
There are several methods that compensate the shortcomings with the standard method.
The conservative approach is to look for the missing swing point when you have 2 consecutive swing highs (or swing lows). For example, after the swing high (#3) is detected and that there is no swing low identified since last swing high (#1) because there is no swing low with N equals 3 or more bars, we can go back to look for the swing low (#2) in between.
Another approach is based on the fact that if a swing extreme is exceeded there ought to be a swing extreme in the opposite direction. So, instead of waiting for swing high (#5) to occur first, once the price level defined by swing high (#3) is exceeded, we know there must be a swing low (#4) somewhere after swing high (#3). This method compensates the standard and conservative approach in identifying swing points earlier in some cases.
Chart Readers Way
Do we human really need to be so precise in defining every single swing points?
The answer is no. If you try to do this the computer way you will always be slower than the computers. The computers are designed to uncover information by mass scale scanning on data. If you try to focus so much on finding the swings like the computers, it will stress you out quickly.
Human works on insights. We should not duplicate the computers’ method in finding swing points. In general, by using charts on one instrument with different timeframes, we can easily figure out the important swing points.
To keep things simple, follow these rules.
1. If it is clearly a swing point to you in your main timeframe, then it is.
2. If it looks like a swing point to you but you are not sure, and that it is clearly a swing point in the immediate lower timeframe, then it is a swing point in your timeframe too.
3. If it is not clear in your timeframe where the closest 3 swing points are, look at the next higher timeframe for clues.
The Importance of Swing Extremes
The most important thing with swing points or swing extremes is that they are proven turning points where price stopped going in one direction and reversed. It gives you confirmed information that a particular price acted as support (where price stopped going lower) or resistance (where price stopped going higher). This information is visually available to all the participants in the market. It is like a public message broadcasted to all participants. Hence the swing points will affect the market participants when price is moving near these them.
As chart readers, we care about how price moves from swing point to swing point. The way a market swings will give us clues whether it has certain bias to move in a particular direction. These structured swings are known as chart patterns.