Technical Analysis Explained
Page 19
FIGURE 13.7 Mega Oversold
Chart 13.2 features the Spider Technology ETF (symbol XLK) at the 2009 primary bear market low. See how the high reading in the 10-day ROC exceeds anything seen prior for a classic mega overbought signal. This is quite remarkable when you remember that the first sign of a primary trend reversal is given within 10 days of the bear market low. This is not sufficient evidence to call a turn, but certainly enough to alert the observant analyst to be looking around for confirming evidence, such as a break above the horizontal trendline flagging the completion of a double bottom.
CHART 13.2 Spider Technology ETF 2005–2009 Mega Overbought
5. Extreme Swings The extreme swing is another phenomenon that signals a dramatic shift in psychology. It reflects the idea that some primary trend reversals are signaled by a swing from unbelievable exuberance as the bull market reaches its peak, to one of complete despondency and depression as the first bear market setback gets underway. The opposite is true of a transition from a primary bear to a primary bull market. In order for an extreme swing to develop, it is necessary to experience a prolonged uptrend or downtrend. The extreme swing then appears in a momentum indicator by an especially strong move in the direction of the then-prevailing trend, as shown in Figure 13.8. This is then followed by an extreme reading in the opposite direction. In Figure 13.8 we see a blow-off to the bull move as the oscillator reaches a highly overbought reading. This is subsequently followed by a price decline that pushes it to the other extreme. Such action indicates a dramatic shift in sentiment as market participants change from a mood of euphoria to one of despondency as the market eventually reacts in the opposite direction to that originally expected.
FIGURE 13.8 Bearish Extreme Swing
In order to qualify for an extreme swing, the first swing must represent the strongest move in several years, certainly the strongest since the initial thrust from the previous bear market bottom. It is really a climax move for the bull market. The second swing to the downside should really be a mega oversold, though in some cases, an extreme oversold will suffice.
This phenomenon undoubtedly occurs because the first swing encourages participants who have been right about the prevailing trend and discourages those who have been wrong. In the case of a bull market, the final rally also squeezes out all of the remaining shorts, so when the trend reverses, there is virtually no buying activity from speculators covering short positions. The preceding sharp advance also encouraged buyers who could see that there was only one way prices could go, and that was up. As a result, decisions on the buy side are made carelessly and without thought for the fact that prices may move the other way. When they do, such individuals are flushed out of the market with no quarter given. Since there are few short sellers able to pick up the pieces, the price drops ferociously.
Extreme swings also develop between a bear and bull primary trend, as featured in Figure 13.9. In this case, though, the mood swing is from total despondency and depression as the bear market squeezes out the last of the bulls to one of disbelief as the market reverses to the upside. At market bottoms, it is the shorts who gain confidence from the sharp and persistent downtrend. Even the strongest bulls are forced to capitulate, and eventually there is no one left to sell. Then, during the rally phase, the shorts are forced to cover and new buying comes in because of the perceived improvement in the fundamentals. Since there is virtually no one left to sell, prices shoot up and a mega or extreme overbought is registered.
FIGURE 13.9 Bullish Extreme Swing
Needless to say, extreme swings are quite unusual, but when you can spot them, it really pays to follow their lead since a new trend invariably results.
Chart 13.3 shows an example of a bullish extreme swing for the China iShare (symbol FXI), at the 2007–2009 primary bear market low. Note that in this case the bullish part of the pattern was also a mega overbought condition. It barely qualified, though, because although it was a multiyear overbought following a bear market, that decline was only a few months longer than our minimum requirement of 9 months for one of these phenomena.
CHART 13.3 iShares FTSE China 25 ETF 2005–2009 Extreme Swing
Major Technical Principle Mega and extreme conditions represent preliminary signals of a primary trend reversal. Confirmation by the price usually puts the issue beyond reasonable doubt.
6. Divergences The ball example used at the beginning of the chapter showed that maximum velocity was obtained fairly close to the point at which the ball leaves the hand. Similarly, prices in financial markets usually reach their maximum level of momentum ahead of the final peak in prices. In Figure 13.10, this is shown at point A.
FIGURE 13.10 Momentum and Divergences
If the price makes a new high, which is confirmed by the momentum index, no indication of technical weakness arises. On the other hand, if momentum fails to confirm (point B), a negative divergence is set up between the two series, and a warning of a weakening technical structure is given. Such discrepancies normally indicate that the price will undergo a corrective process. It can take the form of either a sideways or a horizontal trading range, or (more likely) a downward one. However, the price will sometimes continue upward to a third top and be accompanied by even greater weakness in the momentum index (point C). Occasionally, the third peak in the momentum index may be higher than the second but lower than the first. Either circumstance requires some degree of caution, since this characteristic is a distinct warning of a sharp reversal in price or a long corrective period.
Figure 13.10 also shows a positive divergence. In this instance, the price makes its low at point E, but this was preceded by the oscillator, which bottomed at D.
Major Technical Principle It is extremely important to note that divergences only warn of a weakening or strengthening market condition and do not represent actual buy and sell signals.
Whenever any divergence between momentum and price occurs, it is essential to wait for a confirmation from the price itself that its trend has also been reversed. This confirmation can be achieved by: (1) the violation of a simple trendline, as shown in Figures 13.10 and 11: (2) the crossover of a moving average (MA); or (3) the completion of a price pattern. This form of insurance is well worth taking, since it is not unknown for an index to continually lose and regain momentum without suffering a break in trend during a long cyclical advance. Examples of this phenomenon occurred during the 1962–1966 bull market in U.S. stocks, and in Japanese stocks between 1982 and 1990.
Major Technical Principle As a general rule, the greater the number of negative divergences, the weaker the underlying structure.
A good example can be seen in Chart 13.4, which shows the Nikkei Index violating an important 3½-year secondary trendline after the 13-week ROC indicator had negatively diverged several times with the index. As a result, the final rally was accompanied by very little in the way of upside momentum. It would have been a mistake to sell on any of the prior divergences, but a very timely sell signal was generated by waiting for a confirmation in the form of a trend break in the index itself through a negative 65-week EMA crossover.
CHART 13.4 Nikkei 1995–1990 Negative Divergences
Major Technical Principle A divergence that develops close to the equilibrium line is often followed by a sharp price move when confirmed by the price.
At point C in Figure 13.11, the price moves to a significant new high, but the momentum indicator is barely able to remain above the equilibrium line. Such a situation demands the utmost caution when accompanied by a trend break, for it is usually a sign of extreme technical weakness and is often, though certainly not always, followed by a very sharp decline. The opposite type of situation (Figure 13.12) in a bear market should be viewed as a very positive characteristic, especially if the upward trend break in price is accompanied by high volume. The more explosive the volume, the more reliable the signal is likely to be.
FIGURE 13.11 Extreme Bearish Divergence
FIGURE 13.12 Extreme
Bullish Divergence
In a sense, it is possible to equate momentum divergences and price trend breaks with dark clouds and rain. If you look up at the sky and observe dark clouds, common sense tells you that it will probably rain, but you do not know for sure until you can hold out your hand and actually feel rain falling. In other words, the clouds (like the divergences) warn of the deteriorating weather (technical condition), but the change is signaled only by the first raindrop (reversal in the price). It is possible to take the analogy a step further by concluding that the darker the clouds (the greater the number of divergences), the heavier the rainstorm (the sharper the price decline) will be.
7. Price Discrepancy Divergence A further indication of subtle strength or weakness is given when the momentum series moves strongly in one direction, but the accompanying move in the price index is a much smaller one. Such a development suggests that the price index is tired of moving in the direction of the prevailing trend, for despite a strong push of energy from the momentum index, prices are unable to respond. This unusual, but powerful, phenomenon is illustrated for both tops and bottoms in Figures 13.13 and 13.14. The mid-1990 rally in the 13-week ROC for the Nikkei in Chart 13.4 represents good example. Note also how the price was turned back a couple of times by the 65-week EMA.
FIGURE 13.13 Bullish Price Discrepancy Divergence
FIGURE 13.14 Bearish Price Discrepancy Divergence
8. Complex Divergences It is widely recognized that price movements are simultaneously influenced by several cyclic phenomena. Because a single momentum indicator can monitor only one of these cycles, it is always a good idea to compare several different momentum indicators based on differing time spans.
One approach is to plot two momentum indicators of differing time spans on the same chart, as shown in Figure 13.15. Since this method tries to monitor two separate cycles, it is wise to choose two widely different time spans. For example, not much could be gained from the comparison of a 12- and a 13-week ROC since they would move very closely together. On the other hand, a combination of 13- and 26-week spans would clearly reflect different cycles.
FIGURE 13.15 Complex Divergence
Most of the time, the two indicators are moving in gear, so this study does not give us much information. On the other hand, when the longer-term indicator reaches a new peak and the shorter one is at or close to the equilibrium line, they are clearly in disagreement or out of gear (point A2, Figure 13.15). This normally, but not necessarily, indicates that a reversal in trend will take place, and it is usually an important one. Even so, it is very important to make sure that any such divergence is confirmed by a reversal in the price trend itself. In Figure 13.15, a trend break does occur, but in Figure 13.16, no reversal took place and the price continued on upward.
FIGURE 13.16 Complex Divergence with Nonconfirmation
Complex divergences also occur in a positive combination, as indicated later on at point B1 in Figure 13.15, but again, it is mandatory to wait for that trend-reversal signal in the price itself.
An example in Chart 13.5 features the United States Oil ETF. Note that it offers a good example of a positive and negative complex divergence, together with a confirmation. Generally speaking, the wider the divergent time spans within reason, the more likely you will be to spot these interesting characteristics.
CHART 13.5 U.S. Oil ETF Complex Divergences
Momentum Trend Reversal Techniques
1. Trendline Violations Occasionally, it is possible to construct a trendline on the momentum indicator by connecting a series of peaks or troughs. An example for an uptrend reversal is shown in Figure 13.17. When the line is violated, a trend reversal signal for the oscillator is generated.
FIGURE 13.17 Bearish Momentum Trend Break
The construction and significance of the break should be based on the principles outlined in Chapter 6. This type of momentum weakness must be regarded as an alert, and action should be taken only when confirmed by a break in the price trend itself (indicated at point AA in Figure 13.17). In effect, the momentum trend break is reinforcing the price trend break, and it offers an additional piece of evidence that the trend has reversed.
An example signaling a new uptrend is featured in Figure 13.18. It is possible for the momentum trend break to precede that of the price by some time, yet it does not generally lose its potency because of this.
FIGURE 13.18 Bullish Momentum Trend Break
Major Technical Principle As a general rule, it does appear that if both lines are violated more or less simultaneously, the or if the price trend is violated first, strength of the signal is enhanced.
It should also be noted that momentum trendline breaks can be confirmed by any legitimate trend-reversal technique in the price, be it a moving average crossover, price pattern, peak-trough progression reversal, etc.
2. Momentum Price Patterns Momentum indicators are also capable of tracing out price patterns. Because of the shorter lead times normally associated with reversals of falling momentum, a breakout from an accumulation pattern, when accompanied by a reversal in the downward trend of the price itself, is usually a highly reliable indication that a worthwhile move has just begun. An example is shown in Figure 13.19.
FIGURE 13.19 Momentum Price Pattern Completion
It is important to use a little common sense in interpreting momentum price patterns. Figure 13.20, for example, shows a breakout from a reverse head-and-shoulders (H&S) pattern that takes place from an overbought condition. This is not to say that such signals will never be valid, but it stands to reason that a breakout from an extreme level is very unlikely to result in a sustainable price move. Remember, technical analysis deals with probabilities, and the odds of a favorable outcome in this case are low. If you want a tip-off, this type of failure typically develops in a contratrend way as a false upward breakout in a primary bear market or false downside move in a primary bull market.
FIGURE 13.20 Overbought Momentum Pattern Completion
Chart 13.6 is rich in examples of momentum trendline breaks and price pattern completions. The September 2012 break of the dashed up trendline is a classic example of why it is important to wait for some price confirmation, as the failure of the price to do this was followed by a really good rally.
CHART 13.6 Barclays iPath India ETF Momentum and Price Patterns
3. Equilibrium Crossovers Some technicians have devised indicators that offer buy and sell signals when the momentum indicator crosses above and below its equilibrium or zero line. Many markets do not lend themselves to this approach, so its implementation depends very much on a trial-and-error basis through experimentation. In any event, it is always a good idea to use this method in conjunction with a reversal in the price itself. Chart 13.7 shows how zero crossovers used in conjunction with 12-month ROC crossovers have consistently given reliable buy signals for the Economist All Items Commodity Index. The two sets of ellipses point up a couple of whipsaw signals.
CHART 13.7 Economist Commodity Index 1969–2000 Equilibrium Crossovers
4. Momentum and Moving Averages By now, it is apparent that all the trend-determining techniques used for price are also applicable to momentum. Interpretation of momentum indicators, as described earlier, depends to a considerable extent on judgment. One method of reducing this subjectivity is to smooth the ROC index by using an MA. Warnings of a probable trend reversal in the price being monitored are offered by momentum moving average crossovers, as indicated in Figure 13.21.
FIGURE 13.21 MA Crossovers
One of the problems associated with this approach is that the momentum indicator is often much more jagged than the price index that it is trying to measure, causing the generation of an unacceptable number of whipsaw signals. It is possible to filter out some of these whipsaws by using a combination of two MAs, as shown in Figure 13.22. Buy and sell alerts are given when the shorter-term MA crosses above or below its longer-term counterpart.
FIGURE 13.22 MA Crossovers Smoothed
Smoothed Momentum Indicators
Another way of incorporating MAs into momentum studies is to smooth the momentum indicator by a long-term MA. The meaning of “long-term” in this case will depend on the type of trend being monitored. For example, a 20- to 30-day time span would be suitable for a short-term price movement, but a 6-, 9-, 12-month or even longer smoothing is more appropriate for a primary trend. Warnings of a probable trend reversal in the price would be offered by a reversal in the smoothed momentum index itself, as shown in Figure 13.23, example a, or by a penetration of the MA through a designated overbought or oversold level, as in example b. The level of the dashed overbought and oversold barrier would be determined on a trial-and-error basis, with reference to a historical study of the relationship between the price and the momentum curve.