Technical Analysis Explained

by Martin J Pring

  Major Technical Principle It is of paramount importance to use momentum analysis in conjunction with some kind of trend-reversal signal in the price series itself.

  Momentum Interpretation

  Rate of Change

  The simplest way of measuring momentum is to calculate the rate at which a security price changes over a given period of time. This is known as a rate of change (ROC) indicator. If it is desired, for example, to construct an ROC using a 10-week time span, the current price is divided by the price 10 weeks ago. If the latest price is 100 and that one 10 weeks ago was 105, the ROC or momentum indicator will read 95.2, that is, 100 divided by 105. The subsequent reading in the indicator will be calculated by dividing next week’s price by the price 9 weeks ago (see Table 13.1); the result is a series that oscillates around a central reference point.

  TABLE 13.1 10-Week ROC Calculation

  This horizontal equilibrium line represents the level at which the price is unchanged from its reading 10 weeks ago (Figure 13.1). If an ROC calculation were made for a price that remained unchanged, its momentum index would be represented by a straight line.

  FIGURE 13.1 ROC Using Percentage Scaling

  When an ROC indicator is above the reference line, the market price that it is measuring is higher than its level 10 weeks ago. If the ROC indicator is also rising, the difference between the current reading of the price and its level 10 weeks ago is growing. If an ROC indicator is above the central line but is declining, the price is still above its level 10 weeks ago, but the difference between the two readings is shrinking. When the ROC indicator is below its central line and falling, the price is below its level 10 weeks ago, and the difference between the two is growing. If the indicator is below its central line but rising, the price is still lower than its level 10 weeks ago, but its rate of decline is slowing.

  In short, a rising ROC indicator implies expanding velocity, and a falling one implies a loss of momentum. Rising momentum should be interpreted as a bullish factor, and declining momentum as a bearish one.

  There are two methods of scaling an ROC chart. Since the choice does not affect the trend or level of the index, the method used is not important, but a brief explanation is in order because the two alternatives can be confusing. The first method is the one described earlier and shown in Figure 13.1, where 100 becomes the central reference point. In the example, 100 (this week’s observation) divided by 99 (the observation 10 weeks ago) is plotted as 101, 100 divided by 98 as 102, 100 divided by 102 as 98, and so on.

  The alternative is to take the difference between the indicator and the 100 level and plot the result as a positive or negative number, using a reference line of 0. In this case, 101 is plotted as +1, 102 as +2, 98 as -2, and so on (see Figure 13.2).

  FIGURE 13.2 ROC Using Plus and Minus Scaling

  Selection of Time Span

  Choosing the correct time span is important. For longer-term trends, a 12-month or 52-week momentum is generally the most reliable, although a 24- or 18-month period can also prove useful. For intermediate trends, a 9-month, 26-week (6-month), or 13-week (3-month) momentum works well. Price movements of even shorter duration are often reflected by a 10-, 20-, 25-, or 30-day span. Reliable short/intermediate movements are often reflected with a 45-day (9-week) span.

  Major Technical Principle The analysis of any technical situation will be enhanced by the calculation of several momentum indicators, each based on a different time span.

  In this way, trendlines, price patterns, or divergences, which may not be apparent in one period, are more apparent in another. The discovery of signs of a trend reversal in several indicators constructed from different time spans adds further fuel to the weight of the evidence. An example of this is featured in Chart 13.1 for the iShares MSCI World Stock ETF (symbol ACWI) just prior to the 2007–2009 bear market. Note that the trendline for the price was violated more or less simultaneously with the 12-month MA for a stronger signal than just the trendline on its own.

  CHART 13.1 iShares MSCI World Stock ETF 2002–20012 Multiple Momentum Trend Breaks

  Principles and Applications of Momentum Indicators

  The following description of the principles and use of momentum indicators applies to all forms of oscillators, whether constructed from an individual price series or from an index that measures internal market momentum, such as those described in Chapter 27.

  These principles can be roughly divided into two broad categories.

  1. Those that deal with overbought conditions, oversold conditions, divergences, and the like. I will call these momentum characteristics. If you study momentum indicators or oscillators, you’ll find that they have certain characteristics that are associated with subsurface strengths or weaknesses in the underlying price trend. It’s rather like looking under the hood of an engine. Quite a lot of the time you can identify mechanical trouble before it becomes self-evident. Momentum and sentiment are closely allied, and the relationship between them is discussed in Chapter 29.

  2. The identification of trend reversals in the momentum indicator itself. I will call these momentum trend reversal techniques. In this case, we are making the assumption that when a trend in momentum is reversed, prices will sooner or later follow.

  Trend-determining techniques, such as trendline violations, moving-average crossovers, etc., when applied to momentum, are just as valid as when utilized with price. The difference, and it is an important one, is that a trend reversal in momentum is just that—a reversal in momentum. Momentum typically reverses along with price, often with a small lead, but just because oscillators change direction, doesn’t always mean that prices will too. Normally, a reversal in the momentum trend acts as confirming evidence of a price trend reversal signal. In effect, this momentum signal performs the act of supplementary “witness” in our weight-of-the-evidence approach. I will have more to say on this one a little later, but for now, take special note of the fact that actual buy and sell signals can only come from a reversal in trend of the actual price, not the momentum series.

  Momentum Characteristics

  1. Overbought and Oversold Levels Perhaps the most widely used method of momentum interpretation is the evaluation of overbought and oversold levels. This concept can be compared to a person taking an unruly dog for a walk on a leash. The leash is continually being pulled from one side of the person to the other as the dog struggles to get free. Despite all its activity, however, the dog can move no farther away than the length of the leash.

  The same principle holds true for momentum indicators in the marketplace, except that the market’s “leash” should be thought of as made of rubber, so that it is possible for particularly strong or weak price trends to extend beyond the normal limits, known as overbought and oversold-levels. These areas are drawn on a chart at some distance above and below the equilibrium level, as in Figure 13.3. The actual boundaries will depend on the volatility of the price being monitored and the time period over which the momentum indicator has been constructed, For example, an ROC indicator has a tendency to move to wider extremes over a longer period than over a shorter one. It is highly unlikely that a price will move 10 percent over a 10-day period; yet, over the course of a primary bull market extending over a 12-month period, a 25 percent increase would not be uncommon. Some indicators, such as the RSI and stochastic, have been specially constructed to move within definite predetermined boundaries.

  FIGURE 13.3 Overbought and Oversold Zones

  When a price reaches an overbought or oversold extreme, the probabilities favor but, by no means guarantee, a reversal. An overbought reading is a time to be thinking about selling, and an oversold one warns that the current technical position may warrant a purchase. In many cases, when a price reaches an overbought extreme, the news is good, participants are optimistic, and human nature tells us to buy. Unfortunately, the opposite is more likely to be the case. On the other hand, an oversold reading is usually associated with a negative news background. The
last thing we want to do is raise our shaking hand, pick up the phone, and call our friendly broker or nervously click online, but that is often a reasonable time to do it, provided the overall technical position is favorable.

  In view of the variability of indicators such as ROC, there is no hard-and-fast rule about where the overbought and oversold lines should be drawn. This can be determined only by studying the history and characteristics of the security being monitored. They should be drawn such that they will act as pivotal points, which, when touched or slightly exceeded, are followed by a reversal in the oscillator. When a particularly sharp price movement takes place, these boundaries will become totally ineffective. Unfortunately, this is a fact of life, but by and large, it is usually possible to construct overbought and oversold benchmarks that are price-sensitive. Again, the market “leash” is made of rubber and can remain in overbought or oversold territory for long periods. Consequently, it is essential to get confirmation from a reversal in the trend of the price itself before taking any drastic action.

  2. Oscillator Characteristics in Primary Bull and Bear Markets I mentioned earlier that the character of an oscillator alters according to the price environment. In a bull market, oscillators tend to move into an overbought condition very quickly and stay there for a long time. In a bear market, they can and do remain in an oversold condition for a long time. In effect, an oscillator is not unlike a migrating bird in the Northern Hemisphere. I’ve divided the price action in Figure 13.4 into a bear market, followed by a bull, and finally another bear market. As we enter the bear phase, the true range of the oscillator shifts to the south, in a similar way to a bird in the Northern Hemisphere migrates south to escape the cold northerly winter. Then, when the bull market starts, the oscillator’s trading pattern migrates north again. As a new bear market begins, just like the bird the oscillator finally shifts south again.

  FIGURE 13.4 Changes in Momentum Characteristics in Bull and Bear Markets

  This is useful information in itself, for if it’s possible to draw parallel horizontal lines like these against an oscillator, it provides a valuable clue as to whether the prevailing primary trend is bullish or bearish.

  Major Technical Principle Oscillators behave in different ways, depending on the direction of the primary trend.

  The second point is that if you have an idea of the direction of the primary trend, you can anticipate what price action might follow from a specific overbought or oversold reading. In a bull market, the price is extremely sensitive to an oversold condition. That means that when you are lucky enough to see one, look around for some confirming signals that the price is about to rally. An example might be the violation of a down trendline, etc. The reason for this sensitivity lies in the fact that the oversold reading very likely reflects an extreme in short-term sentiment. Market participants are focusing on the latest bad news and using that as an excuse to sell. Since this is a bull market, they would be better served by remembering the positive long-term fundamentals that will soon emerge and using this weakness as an opportunity to buy.

  The same thing happens in reverse during a bear market. Traders are focused on bad news, which sends the price down. Then, some unexpectedly good news hits the wires and the price rallies. However, when it is fully digested, most people realize that things really haven’t changed at all and the price declines again. Thus, the overbought reading more often than not will correspond with the top of a bear market rally.

  Looking at it from another perspective, during a bull market, the price will be far less sensitive to an overbought condition. Often, it will be followed by a small decline or even a trading range, as at point A in Figure 13.4. The rule, then, is don’t count on a short-term overbought condition to trigger a big decline because the odds do not favor it.

  Finally, people often point to an oversold condition and use that as their rationale for a rally. Your favorite financial columnist might say “Analysts point out that the market is deeply oversold and a snapback rally is expected.” Once again, it very much depends on the environment. In a bull market, that’s true, but the columnist is more likely to say that “despite a short-term oversold condition, analysts are expecting lower prices because. . .” and then the columnist will go on to list a load of bearish factors justifying his or her position. Remember the media tend to reflect the crowd, which is usually wrong at turning points and do not make accurate forecasts, especially when quoting “experts.” In a bear market, though, a market or stock is far less sensitive to an oversold reading, often failing to signal a rally, or possibly being followed by a trading range, as at point B in Figure 13.4.

  The maturity of the trend, whether primary or intermediate, often has an effect on the limits that an oscillator might reach. For example, when a bull market has just begun, there is a far greater tendency for it to move quickly into overbought territory and to remain at very high readings for a considerable period of time. In such cases, the overbought readings tend to give premature warnings of declines. During the early phases of the bull cycle, when the market possesses strong momentum, reactions to the oversold level are much more responsive to price reversals, and such readings, therefore, offer more reliable signals. It is only when a bull trend is maturing, or during bear phases, that overbought levels can be relied upon to signal that a rally is shortly to be aborted. The very fact that an indicator is unable to remain at, or even to achieve, an overbought reading for long is itself a signal that the advance is losing momentum. The opposite is true for a bear trend.

  3. Overbought/Oversold Re-crossovers In most cases, excellent buy and sell alerts are generated when the momentum indicator exceeds its extended overbought or oversold boundary and then re-crosses back through the boundary on its way to zero. Figure 13.5 demonstrates this possibility. This approach filters out a lot of premature buy and sell signals generated as the indicator just reaches its overextended boundary, but one should still wait for a trend reversal in the price itself before taking action.

  FIGURE 13.5 Overbought and Oversold Re-crossovers

  4. Mega Overboughts and Oversolds As discussed in Chapter 29, there is a close connection between market sentiment indicators and the characteristics of oscillators. Since market sentiment differs widely during a bull and bear market, it follows that such variations are occasionally reflected in changing characteristics of momentum indicators. I have termed one of these phenomena “mega overboughts and oversolds.” A mega overbought is the initial thrust in a bull market following the final low. It’s a reading in the momentum indicator that takes it well beyond the normal overbought condition witnessed in either a preceding bull or bear market. It should, for example, represent a multiyear high for the oscillator concerned—perhaps even a record overbought reading. Such conditions are usually a sign of a very young and vibrant bull market. The very fact that an oscillator is able to even rise to such a level can be used, along with other trend-reversal evidence, to signal that a new bull market has begun. It represents a sign that the balance between buyers and sellers has unequivocally shifted in favor of buyers. It’s something like a person using all his strength to crash through a locked door. It takes a tremendous amount of energy to achieve, but once the door is finally shoved open, there is nothing to hold that person back any longer. In the same way, a mega overbought removes the price from its bear market constraints, leaving it free to experience a new bull market. An example is shown in Figure 13.6.

  FIGURE 13.6 Mega Overbought

  This is about the only instance when opening a long position from an overbought condition can be justified. Even so, it can only be rationalized by someone with a longer-term time horizon. This is due to the fact that whenever an oscillator experiences a mega overbought, higher prices almost always follow after a short-term setback or consolidation has taken place. A highly leveraged trader may not be able to withstand the financial pressure from the contratrend move, whereas the long-term investor can. In most instances, you will probably find t
hat the correction following the mega overbought is a sideways rather than a downward one, but there are just enough exceptions to cause the over-leveraged trader a lot of sleepless nights. Since a mega overbought is associated with the first rally in a bull market, it’s a good idea to check and see if volume is also expanding rapidly. If it takes the form of record volume for that particular security, the signal is far louder because record volume coming after a major decline is typically a reliable signal of a new bull market. Expanding volume is a more or less necessary condition since it is consistent with the idea that buyers now have the upper hand and that the psychology has totally reversed.

  Having said that, there are occasions when a mega overbought is followed not by a reversal, but by a change in trend. In other words, the previous bear market emerges into a multiyear trading range rather than a full-fledged bull market. The point here is that that the low that precedes the mega overbought is not normally decisively violated for many years.

  The same concept also appears in reverse for oversold extremes. Consequently, when a price decline following a bull market high pushes a momentum indicator to a new extreme low, well beyond anything witnessed either during the previous bull market or for many years prior to that, the implication is that sellers now have the upper hand. The fact that it is possible for the momentum indicator to fall so sharply and so deeply is in itself a sign that the character of the market has changed. When you see this type of action, you should, at the very least, question the bull market scenario. Look for telltale signs that a new bear market may be underway. What are the volume configurations on the subsequent rally? Does volume now trend lower as the price rises compared to previous rallies that were associated with trends of rising volume? And so forth. The same possibilities of a change, as opposed to a reversal in trend, also apply in the sense that a mega oversold is typically the first decline in a bear market, but occasionally, it can also signal a change in trend from a primary bull market to a multiyear trading range. An example of a mega oversold is shown in Figure 13.7. Both mega conditions are usually best observed in short-term oscillators with a time span ranging from 10 to as many as 30 days. On weekly charts, it’s also possible to go out as much as 13 weeks, though obviously such signals are less timely than those derived from shorter-term time spans. They never develop from indicators whose construction constrains their fluctuations between 0 and 100, such as the RSI and stochastic.