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August 5, 2004
To read a chart properly
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draw the proper trend lines
by John Brasher, CallWriter Publisher
A common question we
get at CallWriter involves how to properly interpret price
charts on a stock or market. Since charting and technical
analysis is not an exact science, it is possible for different
traders to see different things. This is particularly true
when the chart is not making a really clear cut pattern. Is
a chart showing a trend or is it bound in a trading range?
We try to take emotion and hopeful (or even fearful) anticipation
out of the evaluation process and look at the chart dispassionately.
This issue presents a classic case of "what's the
chart really doing?"
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The single most helpful habit for reading charts
properly is to stick to the basics. For example, an uptrend
requires that price make higher highs
and higher lows, and a downtrend
that it make lower highs and lower
lows. False breakouts are among the most reliable
signals - if you can figure out when a false breakout has occurred.
There is no more basic technique than drawing trend lines on a chart.
However, even in drawing trend lines there is a certain amount of
art, or in our view just common sense. Classically, trend lines
are supposed to be drawn across the highest or lowest price points.
In an uptrending stock the line should be drawn under at least the
two lowest prices, and in a downtrend on top of at least the two
highest prices. Doing this mechanically, however, without considering
the reality of what price has been doing, can lead to drawing inaccurate
trendlines that are meaningless for any purpose.
In this issue we will explore a recent chart on
the Dow Jones Industrial Average (INDU) and see how if lends itself
to different trend interpretations and of course give you our take
on it. First, let's look at a recent daily chart of the INDU. The
INDU rebounded from a 7416 low in March 2003 and was in a strong
uptrend through February 2004, then began the current decline. First
of all, this market is in a downtrend, because until point 7, it
was making lower highs and lower lows. The low at Point 7 was a
bit higher than the one at Point 5, but every succeeding high since
the February market top has been lower than the
ones preceding it. Calling it a ranging market would be extremely
optimistic in my view, because lower lows and highs are not characteristics
of a ranging market. The trend is down. It's not a hard downtrend
and keeps fighting back up, but trends can be anything from very
gentle to almost vertical.
Before I even get to the trend lines, note the
bearish divergences in volume. Recent volume trends have been down,
even recently when the INDU made five highs in a row. Not too convincing,
is it? Look how much of the price uptrend in March and April occured
on declining volume. Well, it's summer in an election year, so no
one is expecting much strength in the market until September. But
remember that one can't just evaluate the price action. Volume is
a very strong confirming signal. Uptrending price should occur on
increasing volume, and vice versa.
On the above chart I've drawn the trend line across the two highest
price points, just as the books say to do it. Note that Points 1,
3 and 4 never even got back to the trend line drawn. More to the
point, the most recent closing price today was far below the "trend
line." But within the trend drawn according to the charting
books, is there an internal trend line that is
more meaningful - in effect, the real trend? Let's look at the same
chart with the trend line drawn to more closely match the battles
the market has won and lost.
This trend line makes more sense in light
of actual price action. Note how the line is drawn across the intermediate
highs at Points 3 and 4. The next interaction of price and trend
line occurs at Point A, when price is falling and holding the trend
line. Price then advances to Point B (but can't even get back to
Point 4) but loses steam and then declines again to Point C. Was
this run up to Point B a false breakout? It was indeed, IF my trend
line is the dominant trend. At Point C price cannot even stay above
the trend line, and in fact can only make a couple of closes above
it, barely above it. Price declines heavily again and recovers to
Point D, but again cannot get above the trend line. In other words,
drawing the line as I have done indicates that the run up to Point
B was a false breakout that the market couldn't sustain. Well, no
wonder. Summer is a very weak time for the market. A lot of people
are preoccupied with other things, like the elections and the Iraq
war.
Fundamentalists (the traders, not the church-goers)
would say I'm just drawing lines where it suits me, to make the
chart come out "right." But have I, really? Doesn't the
new trend line better reflect price action? Always remember that
absolute price tops and bottoms can be deceptive, because price
will test support and resistance levels. The absolute
bottoms or tops reached by price during a test frequently don't
matter. The chartist essentially is looking for the consensus number.
That is, if a stock hits a certain level several times, one dip
below or tick above that test the level may not be meaningful at
all.
Example: a stock's price trades
down to the $20 level on several days and one day briefly touches
$18 and comes back to close at $20. The technician should ignore
the $18 level in this example, because it is largely meaningless.
Yes, price was beaten briefly to $18, but that really was a test
of the true $20 resistance level, which is where the trend line
should be drawn.
Volume and the number of times price touches a
particular point are the real determinants. Unless an absolute low
or high is confirmed by heavy volume or multiple touches, it usually
is not as significant as a different level reached several times.
In other words, don't be distracted by testing price action, or
your trend lines will be in the wrong places.
Is my trend line better?
I think it is. At the very least, I've captured the real essence
of the market's movement. It is a perfectly valid practice to draw
internal trend lines (which mine really is), and they often are
much more revealing about true direction and the true chart pattern
forming than trend lines drawn according to the book. Put differently,
sometimes the "book" trend line exalts form over substance.
Ask yourself this: which trend line tells you more: mine or the
"book line? So when drawing trend lines according to Hoyle,
draw an internal trend line, also. You may be amazed by what you
see.
How did I find my trend line? Easy, I started a
trend line at the point the price went over the cliff in February
and simply moved the line around. I started with the "book"
trend line, but instantly saw that it told me nothing and added
nothing to my understanding of the price bars. Moving the line further
down, across the two intermediate tops at Points 3 and 4, really
opened my eyes. I saw instantly that this trend line is the true
battleground. Look how many times price has touched or nearly touched
my trend line. Does anyone really believe this line is a lucky artifact?
By contrast, how significant is the classic trend line, and what
does it add to the technician's understanding of the chart?
What would change my mind? The
only thing that would convince me the "classic" trend
line is the real trend would be for price to advance to the classic
line and test it. Whether it pulled back or broke through wouldn't
matter in evaluating which is the true trend, because a test at
the classic line would be convincing that it is the dominant trend
- and the longer and harder the test, the more convincing. If the
classic line is the dominant trend then the advance to Point B was
not a failed breakout but simply price establishing the trend line.
What's next? I still
can't tell you, especially in the midst of the summer doldrums,
if the market is headed back up or if it's headed down even further.
My guess is it is headed back up, but I won't be convinced until
my trend line is broken to the upside on up volume. Note how the
recent five days of up closes in a row still didn't result in a
single close above my trend line.
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