It has been a testing time in the markets and the articles in this

issue of the Journal demonstrate how the tools of technical

analysis can be used to pick up early on shifts in sentiment. At
our December meeting, Anthony Bolton spelt out the reasons
why he felt the market was due a correction and the press
subsequently reported that Fidelity had been busy buying put
options. Yet again, Anthony Bolton has proved to be right on
the market trend. When John Noyce was asked if he would
write up his talk on the emerging markets he said that he
would but that he felt that the yen was a much more
interesting subject for an article. John submitted his article in
mid-February just before a meeting of the G-7 finance
ministers when the dollar/yen rate was hovering around the
120 level. The lack of any specific policies to support the
Japanese currency as a result of the meeting prompted
renewed selling pressure and the yen briefly popped above
121 before the sharp correction set in that John had so
perceptively anticipated.
In February, the STA was formally contracted by IFTA to create
and mark IFTAs CFTe1 and CFTe2 exams internationally on an
ongoing basis. This is a major coup for the STA and reflects
very well on the high regard with which STA Education is held
around the world.
We would like to take this opportunity to thank Jim Howship
for kindly making his collection of books on technical analysis
available to the Society.
Another person whose contribution to technical analysis
deserves recognition is John Brooks. He has been a technical
analyst for the last 44 years and was one of the founders of
the Market Technicians Association of the USA, later becoming
President of that organisation. He was also one of the first
people to acquire a Chartered Market Technicians (CMT)
designation. Later he served as Chairperson of their
Educational Foundation for many years and was instrumental
in establishing accredited classes at college level. In 1998, John
was given the MTAs annual award for an Outstanding
Contribution to the Field of Technical Analysis, a well deserved
honour. More recently, he was one of the main influences
behind the establishment of the American Association of
Professional Technical Analysts (AAPTA) and he currently
serves on its Board of Directors. However, his work in the
promotion of technical analysis has not been only confined to
the US. He was one of the founders, in 1985, of the
International Federation of Technical Analysts (IFTA), which
today includes 25 nations and has 7000 members worldwide.
John served as IFTAs Chairperson from 1996-1998, and
through this and other varied roles in IFTA, Brooksie has been
a guiding light of the organisation and has made many friends
in technical analysis round the world. He has also been a
member of the STA for a number of years. Beside all this, John
is the author of a book called Mastering Technical Analysis. For
his great contribution to technical analysis worldwide, the
Board has voted to make him a Fellow of the Society.
Finally, advance warning of a couple of dates for your diaries.
Reuters have kindly offered to host the Societys summer
party on 11th July and this years IFTA conference will be held
in the Egyptian Red Sea resort of Sharm el-Sheikh from 8-11th
November.
IN THIS ISSUE
STA Exam Results. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
P. Desmond Food for thought . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
A. Bolton How I use technical analysis
in my decision-making process . . . . . . . . . . . . . . . 4
R. William Book review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Bronwen Wood Memorial Award . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
D. Watts Bytes and pieces . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
J. Noyce A technical assessment of the yen. . . . . . . . . . . . 6
R. Adcock Momentum, trending and sentiment. . . . . . . . . 8
COPY DEADLINE FOR THE NEXT ISSUE
31ST MAY 2007
PUBLICATION OF THE NEXT ISSUE
JULY 2007
FOR YOUR DIARY
Wednesday 9th May Monthly meeting
Wednesday 13th June Monthly meeting
Wednesday 11th July STA Summer party
at Reuters
N.B. Unless otherwise stated, the monthly meetings will take
place at the Institute of Marine Engineering, Science and
Technology, 80 Coleman Street, London EC2 at 6.00 p.m.
April 2007 The Journal of the STA
Issue No. 58 www.sta-uk.org
MARKET TECHNICIAN
MARKET TECHNICIAN Issue 58 March 2007 2
CHAIRMAN
Adam Sorab: adam.sorab@cqsm.com
TREASURER
Simon Warren: warrens@bupa.com
PROGRAMME ORGANISATION
Mark Tennyson-d'Eyncourt: mdeyncourt@csv.org.uk
Axel Rudolph: axel.rudolph@dowjones.com
LIBRARY AND LIAISON
Michael Feeny: michaelfeeny@yahoo.co.uk
The Barbican library contains our collection. Michael buys new books for it
where appropriate. Any suggestions for new books should be made to him.
EDUCATION
John Cameron: jrlcameronta@tiscali.co.uk
IFTA
Robin Griffiths: robin.griffiths@rathbones.com
MARKETING
Clive Lambert: clive@futurestechs.co.uk
David Sneddon: david.sneddon@csfb.com
Simon Warren: warrens@bupa.com
Karen Jones: karen.jones@ commerzbank.com
MEMBERSHIP
Simon Warren: warrens@bupa.com
REGIONAL CHAPTERS
Alasdair McKinnon: Mailasm@aol.com
SECRETARY
Mark Tennyson dEyncourt: mdeyncourt@csv.org.uk
STA JOURNAL
Editor, Deborah Owen: editorial@irc100.com
WEBSITE
David Watts: DWattsUK@aol.com
Simon Warren: warrens@bupa.com
Deborah Owen: editorial@irc100.com
Please keep the articles coming in the success of the Journal depends
on its authors, and we would like to thank all those who have supported
us with their high standard of work. The aim is to make the Journal a
valuable showcase for members research as well as to inform and
entertain readers.
The Society is not responsible for any material published in The Market
Technician and publication of any material or expression of opinions
does not necessarily imply that the Society agrees with them. The
Society is not authorised to conduct investment business and does not
provide investment advice or recommendations.
Articles are published without responsibility on the part of the Society,
the editor or authors for loss occasioned by any person acting or
refraining from action as a result of any view expressed therein.
Networking
WHO TO CONTACT ON YOUR COMMITTEE
Autumn 2006
DISTINCTIONS
Michael Estrey Khaldoun Al-Janini
Christopher Hine K J Perumal Raja
Mark Andrew Lim
PASS
Tarek Al-Showaier Marc Dagher
Mark Paul Cullen Mathieu Lebrun
Matthew Daniels Fabien Letheuil
Stefano Errico Ngian Yew Pin
Nicole Ooi Alhaitham Al-Ghothami
Hussain Alquatari Nabil Effat
Visual Trader 3.0
Nirvana Systems, Inc has released Visual Trader 3.0 which provides
a visual tool for equity sector ranking and analysis. The program
enables the user to identify sector rotation and then focus in on
strongest or weakest stocks in those sectors. It allows the user to
play back past market behaviour to test a strategy and see the
results. A visual demonstration is available, see:
ttp://www.visualtrader.com/VTDemo/
SnapSheets
every popular Worden, with its Telechart software, has released a new
modular charting package. You simply add the necessary modules
you need together as your needs change by mixing and matching
the pieces you want. As all the standard modules, such as charting,
back testing and scanning etc, communicate with all the others it
makes a seamless package. Combine this flexibility with Wordens
data and you have an excellent equity analysis package, see the
website for further details:
http://www.worden.com
Data Conversion
With so many propriety databases for so many TA programs, data
conversion can become a real issue. There are very few flexible
programs that can convert between data formats. One of the few
tools is Data Shark that can convert between formats like
Metastock,Omega, AIQ,ASCII Telechart etc. It is a pity they dont
have more UK format TA conversion tools, but they may add other
data types upon request. One of the few essential tools for the tool
box.
http://www.datasharks.biz/DataConverter_Info.php
Another Data Source
Apart from Q-data in the UK, searching for longer terms data series
can be frustrating. Finding long term data on the North American
markets is also challenge so Prophet Data may be worth a try they
have decades of data series for most North American Equities and
Futures in Metastock data format. A useful resource and especially
when combined with a data converter.
http://www.prophet.net/
STA diploma exam
Bytes and pieces
Issue 58 March 2007 MARKET TECHNICIAN 3
One of the indicators that we
monitor at Lowrys reports is the
percentage of Lowry stocks
trading above their 10-day
moving averages. This indicator
has proved to be very helpful for
our clients in measuring the short
term extremes of market
selectivity. A number of
significant buying opportunities
have been identified in the past
after periods of market weakness
have caused the percentage of
stocks above their 10- day moving
averages to drop below 10%.
For example, as a result of the
recent intense stock market drop
beginning on February 27th, the
10-day % indicator dropped from
its early-February07 peak of
84.6% to a low of just 3.77% on
March 5th, reflecting a deeply
oversold market condition. The
table below lists all similar cases
since 1990 in which the
percentage of stocks above their
10-day moving averages has
dropped below 10%, and the
resulting market action, as
measured by the DJIA, over
subsequent 2 weeks, 3 months,
and one year periods:
In summary, since 1990, there
have been 18 cases in which the
percentage of stocks above their
10-day moving averages has
dropped below 10%. In 78% of
those cases, the market was up an
average of 2.98% in the next two
weeks. In 94% of the cases, the
market was an average of 8.9%
higher in the next 3 months. And,
in 94% of the cases the market
was up an average of 20.1% in the
next 12 months. The chart below
of the Dow Jones Industrial
Average shows the approximate
locations of each of the dates
included in the above table.
Paul Desmond is the President of
Lowrys Reports Inc., the oldest
technical advisory service in the US.
www.lowrysreports.com
Food for thought
By Paul Desmond
Date Lowest DJIA % Change DJIA % Change DJIA % Change
Level 2 weeks later 3 months later 12 months later
Aug. 23, 1990 1.93 + 5.5% + 2.30% + 21.1%
Oct. 11, 1990 9 + 5.0 + 5.8 + 25.9
Nov. 19, 1991 9.75 - 0.7 + 11.9 + 8.9
Apr. 4, 1994 4.06 + 0.8 + 1.7 + 16.0
July 16, 1996 6.14 + 2.3 + 12.2 + 48.8
Oct. 27, 1997 3.07 + 5.5 + 10.5 + 16.8
Aug. 31, 1998 4.71 + 6.4 + 20.9 + 43.6
Sep. 21, 2001 4.51 + 10.7 + 21.8 - 4.4
July 23, 2002 1.89 + 7.4 + 10.9 + 19.4
Sep. 24, 2002 5.55 - 2.4 + 10.6 + 22.7
Jan. 27, 2003 4.94 + 0.9 + 6.0 + 32.8
Mar. 12, 2003 7.13 + 9.0 + 21.6 + 34.1
May 10, 2004 7.45 - 0.32 - 0.45 + 2.91
Jan. 5, 2005 6.94 - 1.19 - 0.49 + 2.68
Apr. 15, 2005 9.41 + 1.04 + 5.49 + 9.78
Oct. 12, 2005 7.93 + 1.25 + 7.3 +16.94
May 18, 2006 8.55 + 1.07 + 1.86 ?
June 13, 2006 7.93 + 2.04 + 7.4 ?
Feb. 27, 2007 8.04 ? ? ?
Average Gain/Loss 2.98% 8.88% 20.90%
MARKET TECHNICIAN Issue 58 March 2007 4
General investment approach
The main thrust of Anthony Boltons investment approach is to
look for securities that are, in his view, mis-valued by the market.
He is, therefore, very much a contrarian investor, buying into
unfashionable companies and sectors. In particular he tries to
identify:

Industry anomalies

Turnaround or recovery situations

Unrecognised growth

Attractive assets

Corporate potential
Bolton is currently responsible for managing Fidelitys Special
Situations Funds. Most of the portfolio is invested in mid-cap
and larger small-cap stocks and around 15-20 per cent is in
overseas companies. The average holding period for a stock is
one to two years.
Technical analysis overlay
Bolton finds technical analysis provides a useful discipline to his
portfolio management. He uses it as a cross check for his
fundamental views and to help decide when it is appropriate to
bet against the crowd and when it is not. He also uses it to
determine the size of a position. If the fundamentals look good
but are not confirmed by a positive technical reading, he will
open a relatively small position and add to it if and when the
technicals signal an upturn in buying momentum. When the
fundamentals and technicals are both giving positive signals, he
will take a bigger initial position in the stock. If the technicals
begin to deteriorate, he will start selling the stock.
Technical analysis also helps to pick up on changes in sentiment
and investment flows. It is the general perception of what a stock
or market is worth that is important in determining what
happens to the price. Another important indicator of sentiment
within a company is what the directors are doing in terms of
buying and selling their own companys shares. The rise in
directors sell to buy ratio on both sides of the Atlantic is just one
of the reasons why Mr Bolton believes it is likely that we will see
another leg to last years correction.
Market outlook
Mr Bolton reminded the audience that he first addressed the STA
in 1987 and almost two decades later he is again in a bearish
frame of mind. The reasons for his more cautious stance are:

The bull market is over three and a half years old. Since March
2003 the market is up 87% which is around the average rise in
bull markets but in terms of length it is the second longest
since 1966 (see chart 3).

Value opportunities are scarce (see chart 4).

Investors appetite for risk has returned and they are not
differentiating between high and low risk stocks (see chart 5).

There has been a mini bubble in both commodities and
infrastructure investments
Against these negatives, he pointed out, must be weighed the
very strong support that is coming into the market from private
equity funds.
How I use technical analysis in my
decision-making process
This article is a brief summary of a talk given by Anthony Bolton to the Society on 6th December, 2006
Chart 2: UK & US equities with directors selling and buying
Chart 1: How I look at a company
Chart 3: UK (FTSE All Share) bull markets > 20% since 1966
Issue 58 March 2007 MARKET TECHNICIAN 5
Summary
The bull market is long in the tooth and so this is the time to be
focusing on the good quality, larger growth stocks. In Fidelitys
Special Situations media stocks have the largest weighting
followed by oil and gas.
Mapping the Markets
Deborah Owen and Robin Griffiths, Profile Books 2006 20
It is a privilege to commend this book to the great multitude of
investors, traders and analysts, who are eager to enhance their
knowledge of the global financial markets - whether in equities,
currencies, interest rates or commodities.
"Mapping the Markets", the brainchild of two well-known
practitioners in the world of technical research; Deborah Owen
and Robin Griffiths, amalgamate the disciplines of economic and
technical analysis, showing how investors can position themselves
to benefit from both specialties.
The authors expound on the work of Joseph Schumpeter - this
being the backbone of their methodology - and illustrate how
Schumpeter's 'three-cycle schema' culminate in trends in the
stockmarket that last for generational periods of time (secular
timeframes) or in cycles of shorter duration. Particularly
interesting is the revelation of the four-year cycle in the US
stockmarket, otherwise dubbed the Kitchin cycle in Schumpeter's
work, and is shown to have become phase-locked with the US
presidential-election cycle.
At the microscopic level, the authors share a unique system for
identifying stocks and conducting top-down analysis that begets
from the four-year cycle. The methodology aims to identify the
strongest trending markets and stocks based on short, long and
relative strength trends and is particularly useful for determining
sector rotation within the business cycle. Having applied this
analysis, they illustrate simple chart patterns that can be utilised
in conjunction with this methodology to sharpen market timing.
On another note, the book is instrumental in revealing how more
esoteric concepts like demographics and natural resource
allocation are key in paving the economic destinies of countries
and is apropos in interpreting China and India's boom story.
Finally, it is worth highlighting that the primary strength of this
book is separating the wheat from the chaff to provide a no-
nonsense approach to deciphering financial markets in their
changing landscapes.
I only wish that I had this book ten years ago!
Chart 4: On price-to-book, equities are expensive
Chart 5: US sentiment model
Chart 6: Positioning
Book review
By Ron William, Bloomberg
Bronwen Wood Memorial Award
The Bronwen Wood Memorial Award is normally awarded to
the candidate with the best mark in the diploma examination
but this year it was felt that two candidates deserved to be
recognised. Michael Estrey and Mark Andrew Lim submitted
exceptionally good papers and impressed the examiners with
the depth and range of their knowledge of technical analysis.
They both obtained 94%. Congratulations to both of them.
MARKET TECHNICIAN Issue 58 March 2007 6
The major cross exchange rates against the yen (cross/JPY) based
in October 2000 and, since then, we have seen a marked weakening
of the yen against all of the major developed currencies, i.e. the
cross/JPY rate has moved higher. The initial part of this move did
not receive that much attention but, over the last few months, as
multi-year highs have been reached on a number of well-traded
crosses, such as GBP/JPY, the yens decline has hit the headlines. This
is a good time to take a step back and look at the big picture. Is the
yen really going down for ever as some analysts would have us
believe or is it just the time we should start to be cautious? This
should be a time when technical analysis is at its best.
The chart below shows how the yen has performed versus an
equally weighted basket of the G10 currencies; USD, EUR, GBP,
AUD, CAD, NZD, NOK, SEK and CHF. A move higher on the chart
reflects yen weakness, whereas a move lower shows the yen
strengthening (the same convention as the quotation of individual
G10/JPY foreign exchange rates).
Even a quick glance at the chart shows just how far the market has
moved over the last six years. In October 2000 the basket stood at
74.35, by January 07 the monthly close was 114.74 - a rally of
54.32%. Keep in mind thats a 54.32% depreciation of the yen on a
very broad basis; it being, by definition, the average amount which
the JPY has depreciated against the constituents of the basket over
that period. No wonder funding in yen has become so engrained in
the psyche of global investors and households alike. Fund at near
zero and your liability also depreciates over time.
Thats enough of the history, whats going on technically? The first
thing to note is that the basket has now reached the major high
made in August 98. That is the point from which the last major
correction in the basket began when - although arguably different
in structure - the last global carry trade had built up. Those in the
foreign exchange markets at that time will remember the speed
and depth of the correction that followed. At this point its
important to highlight that the aim of this article is not to
scaremonger that a similar move is coming now. With our old friend
hindsight, we know that there were specific catalysts which helped
to speed up the market correction in 98. However, technical
analysis is all about looking ahead, and seeing how strong a market
reaction is likely to be if, and when, a suitable catalyst emerges. A
good indicator to look at in this regard is the period the market has
been above/below certain moving averages, in order to ascertain
whether the market has become historically stretched in terms of
the duration of the current trend. We believe the 55-day moving
average is very helpful in this respect (note 55 is part of the
Fibonacci Sequence; 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55....). The daily chart
of the same G10/JPY basket shown below highlights just how long
the market has been above this particular average. It is the longest
above-trend period in history and is given added significance by
the fact that the market closed above the 98 high on 26th May 06
and has not traded below this level since.
This extended period does not, in its own right, give a signal to look
for a reversal. In terms of the number of days above the average,
the market has been moving into uncharted territory for some time
now but it does indicate the size of positions that have been built
up in the carry trade.
From a technical stand point, the market is, therefore, very stretched
as it approaches a major pivot.
So what would the signal of a larger correction or turn be?
Theoretically, the answer is relatively straight forward. At the time
of writing (mid-February), the test of the moving average as
support is the eleventh such test since the market closed above the
moving average in May 06 - an incredible number of tests of one
individual support level. In the light of this, a close below it would
seem to be pretty significant and, in our experience, would open
the way for a potential target of the 200-day moving average which
stands 3.5% below the 55-day moving average. That may not sound
much in terms of a correction, but two things are important. Keep
in mind that this would target a 3.5% broad appreciation of the yen.
Also, the 200-day moving average is only an initial corrective target;
corrections/turns will often extend further than the initial target.
Earlier we highlighted that the G10 basket has now reached the
major high dating back from 98 (August). With this in mind, its
interesting to look back at how the market subsequently traded, and
specifically the moving average setup, after the 98 highs were set.
A technical assessment of the yen
By John Noyce
Figure 1
Figure 2
Issue 58 March 2007 MARKET TECHNICIAN 7
The two charts shown above in chart 3 show just this; the upper
one being the G10/JPY basket back in 97-98 and the lower one the
baskets recent performance. As can be seen, the relationship with
the 55-day moving average worked in 98 too. As the market went
into the January 98 highs, it had also been above the 55-day
moving average for a significant period - although not anything
like as long as the current position. Once it had broken down below
the 55-day moving average, it quickly moved lower to slightly
beyond the 200-day moving average before again beginning to
trend higher. As the market moved up to the actual cycle high in
August 98, the basket rate had, therefore, been above the same
average for an extended period. The close below this line was a
significant signal, and note that the correction (in fact turn in trend)
that took place afterwards took the market significantly beyond the
initial 200-day moving average target.
To sum up: Our G10/JPY basket is now at, and correcting from, a
major long term pivot. It is also more stretched in terms of the
period it has spent above/below this one moving average that it has
ever been before. The risks of a larger downside correction grow.
With that broad view in mind, we will now look at USD/JPY
(Chart 4), one of the most important yen-related currency pairs. It,
too, has moved significantly higher (in this case over the past two
years), moving from a low of 101.67 in January 05 to a high of
122.20 in January this year. At the lows in early 05, you would
regularly hear phrases such as ..any bounce is a sell, the rate just
has to go down, its only the BOJ thats going to hold it up.. Were
now a long way above those levels and the Bank of Japan hasnt
intervened in the USD/JPY market for over two years. With the
upward move has come a sea-change in sentiment. Now the
common phrase is ..youve got to buy the pull-back, think of the
carry, so what if the Bank of Japan is going to raise rates to 0.5%?
Well, the jury is still out on whether this is a major turn or not but
just as at the lows in January 05 were a warning sign that the
market was basing prior to an upside turnaround, so there are
warning signs now that the market is topping out and potentially
turning to the downside or at least a meaningful correction.
At first glance the monthly chart of USD/JPY, appears to have cleanly
broken above the long term downtrend from the 98 highs and two
other resistance points that come in around the same level.
But is it really that simple? If you look at the weekly price action
shown on Chart 5, it is not so clear. Although not as significant as
the support provided by the November 99 low at 101.25 in January
05, the December 05 high (resistance level) comes in at 121.40.
Thus far, the market has not been able to hold above this important
resistance point. Instead, it has spent three weeks consolidating
under it in a volatile fashion. To end the period of consolidation the
market has now posted a bearish weekly reversal (to achieve this, at
some point during the period, the market must trade above the
prior periods high, but then reverse to close below the previous
periods low). In this case, the sequence was achieved with a close
below 119.96. In turn, this is causing weekly momentum to turn
lower from very similar levels to that seen at the December 05
highs, i.e. the high from which the prior significant downside turn
was made. The daily charts have also formed a double top which,
although only a short term development, targets a move to 117.78
calculated as the distance from the neckline (6th February low at
119.96) to the trend across the two highs which create the double
top (29th January and 12th February highs) projected from the
neckline itself (6th February low at 119.96).
In conclusion, the warning signs are that just as USD/JPY appears
to be making a clear break to the upside on the monthly charts, it
is actually becoming tired and susceptible to a downside turn.
Given the developments discussed previously on our G10/JPY
basket, the warning signs are that a material turn to the downside
may not be far away, just as it appears the all clear has been
sounded for the trend to continue. Remember, the carry trade
will go on for ever, just as USD/JPY was a sell on any bounce at
the lows in January 05.
John Noyce, Technical Analyst, Citigroup
Figure 3
Figure 4
Figure 5
MARKET TECHNICIAN Issue 58 March 2007 8
Throughout my years within the financial industry and, in
particular, my involvement with technical analysis, its become
apparent to me that there are three distinct areas that dominate
my market appraisal sentiment, momentumand trending. I have
found that a consistent approach to each gives me a reliable
insight into where the market stands at the present and, more
importantly, where it is likely to go over the coming days, weeks
and even months.
Sentiment
It is always difficult to develop a true feeling for sentiment, as it
often comes down to an individuals own subjective reading of
how a market has been trading (which in turn actually reflects
how that person is positioned). Too bearish and the directional
risk is likely to swing to the upside; too bullish and more often
than not, you have to think very carefully about being long. True, a
number of services are available (the traders positioning report
by the CFTC and Stone McCarthy, to name but two), however,
using these takes time to allow the data to be collated and
reported. For example, consider the scenario where data is
collected for a period ending on a Tuesday, yet wont be
published until the following Monday and an event such as the
U.S. payroll number or another important release occurs during
that between time. Again, it comes down to a subjective reading
of how the market has traded between data collection and
release. So is this data really all that useful in determining
sentiment and, as such, directional risk?
I firmly believe that these services are helpful for the longer term,
since why should a few data releases change a developing/on-going
trend in positioning that cant be picked up at the next publication
date. However, my own analysis is mostly short term (3-7 days),
which is why I have a problem with these particular positioning
services. So does it again come down to only a subjective reading
of how the market is positioned which can work for a while but
never on a consistent basis or is there a more objective way to
approach the subject of sentiment?
For me, the best measure of day-to-day sentiment is to look at
how the market is actually trading and set clear objective criteria
to price action. Get that right and at least half the battle is won. To
do this, I use Japanese candlestick charts.
Candlestick Analysis
The Japanese were the first to use candlestick analysis, in trading
the rice futures market. In the 1700s, a Japanese trader named
Homma established that, while there was a supply:demand link
for rice, prices were also influenced by the emotions of the
traders. Homma realised that he could gain an edge for his
trading from understanding how emotion helped predict future
price movements.
Candlestick analysis, with pattern names such as Piercing Line,
Morning Star and Doji, initially appears quite confusing to a
beginner. But it really is very easy, and best of all, provides a very
objective approach to all markets (not just rice!). If the criteria of
a particular reversal arent met, then it isnt a reversal.
The candle itself simply represents the difference between the
opening price on any given day and the closing price. If the day
closes higher than the opening, then the body of the candle is
white; if its lower the candle body is black. The days high and low
are marked by vertical lines extending above or below the body
(the shadow).
Why is the open/close relationship so important in terms of
sentiment? Quite simply, the opening price represents the first
opportunity to trade, and gives us the first reference of what the
market feels is value. The close is the last reference, and the
further the closing price is from the open, the more significant
that day is in terms of bullish or bearish sentiment. The only other
type of candle is a Doji, which occurs when there is no difference
between opening and closing prices, so no body is evident. This
highlights trader indecision as to just where directional risk lies,
and often occurs after a strong move either up or down,
signalling that a consolidation is due.
Also important when gauging sentiment within a candlestick chart is
how a market closes in relation to the days high or low. A trader
always has a decision to make coming into the close, whether to
hold a position overnight (or the weekend). If one is confident
that a position is right and that the market will continue to move
in ones favour, theres no position change and the trader looks for
the trend to remain in force. If this feeling of confidence is
reflected across the market, no substantive closing of positions
will develop, so the settlement will be towards the days high or
low (depending on the general trend). But consider the situation
if that same decision process resulted in traders deciding they
were losing confidence in their view, and thus felt it prudent to
close positions before departing for the day. In such a case,
buying or selling (depending on market positioning) will
materialise coming into the close, causing prices to either sell off
from the days high or rally from the low. If the market has shown
a strong directional move with large candle bodies and
settlements towards the limits of the days range but then
closing prices suddenly start to fall back from the highs we can
assume that bullish confidence is waning, increasing the risk of a
Momentum, Trending and Sentiment
By Richard Adcock
Chart 1: Types of Candlesticks
Issue 58 March 2007 MARKET TECHNICIAN 9
more prolonged consolidation phase. [NOTE: I review this further
within stochastic momentum tools.]
Bearing all of this in mind, consider the examples in Charts 2 and
3 (where sentiment changes have been flagged by how the
market closed in relation to the session high); these gave
important signals to just where the directional risks lay for the
longer term. In Chart 2, at the May 2nd low, no bullish reversal
pattern was evident, so the view was that price strength was
limited before the overall bearish trend was resumed and new
lows scored. Price action went on to post five consecutive bullish
white candles as the consolidation developed and traders
perception of value was higher at each close compared to the
opening price. That said, its clear from the actual size of each
candle body that sentiment was never aggressively bullish. Now
look at the blue arrow-highlighted day when prices actually
opened on a bullish gap higher, then hit a new recovery high. At
that point there was nothing to indicate the consolidation/rally
was ending, until, for whatever reason, selling pressure
materialised, the high was rejected, and the closing price was
below the days opening price thus sentiment had turned
bearish again with a black candle posted, breaking the pattern of
white candles. The more bearish themes were developed further
the following session, when an opening gap lower developed,
confirming the negative sentiment and resumption of the on-
going bearish trend.
In Chart 3, we see how this type of sentiment monitoring can
signal the end of a more balanced sideways trading range, and
prompt a new, higher, aggressive trade. For the initial phase of
the highlighted area, it is clear that no dominant force is in place
(the candle bodies relatively small and long shadows above and
below the open/close relationship reflect rejection of the
attempted higher and lower prices; i.e., sentiment is balanced
and prices are moving sideways). However, on the final day of the
highlighted area, we can see that a large white candle has been
posted and the close is actually the session high, so unlike the
previous eight days theres not been any selling into the close,
reflecting a clear change from the neutral sentiment to a much
more bullish position, from which fresh price strength
developed.
So we can see that, by studying the open/close relationship and
how the days representative candlestick body compares to either
the high or low, we can get a very good feel as to whether
sentiment is changing. It should also suggest if we should begin
looking for either a consolidation phase or a resumption of the
ongoing directional trend (of course, that doesnt even begin to
look at reversal patterns that can form).
Candlestick Reversal Patterns
There are a number of reversal patterns that work well on
candlestick charts; each can be very important in highlighting a
sentiment and directional change over a period of just 1-, 2-, or at
the most 3-days. I wont review every pattern, but I will discuss
one pattern from each of these short-term periods, explaining
why I see them as critical in flagging trend changes. For anyone
wanting to look at candlestick patterns in greater detail, I
recommend Steve Nisons book, Japanese Candlestick Charting
Techniques
1
.
Chart 4 shows a bearish reversal pattern it means the market
must have been previously trading within a strong directional up
trend, with limited corrections, new highs being consistently
posted and, predominately white candles all reflecting the
ongoing bullish sentiment. On the day the reversal forms,
everything appears as if the trend is being extended prices
have gapped higher at the open, and further strong support
developed to post a new price high. However, at some time
during the day, a rejection of this new extreme develops and
Chart 2: Sentiment Turns Bearish
Chart 3: Ending the Consolidation
Chart 4: Shooting Star Pattern Bearish 1-Day Reversal
MARKET TECHNICIAN Issue 58 March 2007 10
prices sell off, leaving a large shadow above the open/close
relationship, which in turn is within the lower third of the days
entire range. It doesnt matter if the market closes lower than the
days opening trade (thus the candle body can be black or
white); the activity highlights a clear rejection and shift in
sentiment. If that is confirmed by a black candle the following
day, this marks the end of the bullish trade and the start of at
least a more extended consolidation/correction phase.
On chart 5 as is always the case with any bearish reversal pattern,
the market had been trading within a bullish and consistent
trend. The first day of the pattern appears like any other within
the uptrend, its a bullish white candle and a new recovery high is
scored. The second day then sees prices beginning the session in
a bullish way (with an opening gap higher, and possibly but not
necessarily a new high), but a rejection develops during the day
and prices sell off, closing lower than the opening trade (thus a
black candle body) as well as below the prior days opening price
so this open/close relationship has been completely engulfed.
Clearly, this is a very quick shift in sentiment, going from bullish
on the open to bearish at the close, and it represents the end of
an up trend and a much deeper, prolonged sell-off.
For the pattern to be a bullish engulfing reversal, the market
must have been trading in a downtrend. The first day of the
pattern thus has a black candlestick body, and prices are making a
new low. The next days opening price is lower on a bearish gap,
followed by a strong rally that closes above the previous days
opening price, creating a white candle and engulfing the first
days open/close range.
Again, for any candlestick reversal pattern to be valid, the market
must have been trading within a clear trend, as the smaller the
recovery or correction, the less significant the signal. This is just as
true (if not more so) for the Morning Star pattern, which is a 3-day
reversal, signalling a more important shift in long term sentiment.
As with the prior examples, in the case of the Morning Star
pattern, the first days chart appears as a normal continuation of
the directional trend, with a new low scored and a black candle
posted, as sentiment remains negative with the first reference of
value lower at the close versus the open. However, on the second
day, the market opens on a gap lower (maintaining the bearish
sentiment) but we begin to see sentiment changing, in that
sellers fail to extend the trend lower, and the open/close
relationship is relatively small. The third day of the reversal is
undoubtedly bullish, the session opens on a gap higher (bullish
sentiment; traders want to buy as soon as possible) and a strong
rally ensues (thus a large white candle that closes above the mid-
point of the first days open/close relationship, confirming the
pattern is in place and that the market is setting into a new
bullish trend).
The bearish version of the Morning Star pattern is perhaps not too
surprisingly calledEvening Star, and is a mirror image of the
bullish pattern. The first day is a large white candle, maintaining
the drive to new highs within the bullish trend, followed by a gap
higher on the second day and a small candle body, as sentiment
begins to show the first sign of change. The third day of the
bearish pattern leaves no doubt that the directional shift is
complete, with a gap lower followed by strong selling pressure
that creates a large black candle settling below the mid-point of
the first days open/close relationship.
[NOTE: While some technical analysts dont require it, in any
reversal pattern within candlestick work, I have to see the
following day to confirm the sentiment change (via a white
candle following a bullish reversal and a black one after a bearish
pattern). If no confirmation is seen, I declare the pattern invalid
and of no significance to the daily and weekly view.]
Momentum
I consider momentum-based indicators extremely valuable in
determining important turning points for markets, but they can
be quite infuriating, given their habit of highlighting overbought
readings, yet the market continues to stay that way, with prices
continuing to power ahead. In certain circumstances I would even
argue that overbought momentum readings are actually a buy
signal, as they often confirm that sentiment is bullish (which is
what will drive the market higher). That said, my use of momentum
tools is based more from a timing perspective, with any cross up or
down often an important signal, whether it be against overbought,
oversold or neutral readings.
Stochastic Momentum
Within his work, George Lane
2
highlighted that as prices rise (or
fall) strongly within a bullish or bearish trend, closes tend to be
towards the high or low of the days range. This reflects that
sentiment remained strong (traders not looking to take profits
coming into the close, and content to carry risk overnight).
Stochastics extend this approach to a slightly longer period by
Chart 5: Engulfing Pattern Bearish 2-Day Reversal
Chart 6: Morning/Evening Star Pattern Bullish/Bearish 3-Day Reversal
Issue 58 March 2007 MARKET TECHNICIAN 11
taking the latest price and comparing it to the range of the last X
number of days (X = any value; for me, 10 days gives the best
signals). So as prices move within a directional trend, the
stochastic indicator line will rise or fall, until the current closing
level begins to move away from the extreme of the 10 day range,
reflecting changing trader sentiment and a recovery/correction
about to develop from oversold/overbought readings.
However the main problem with momentum indicators is that
they can get over-extended and stay that way for prolonged
periods as prices maintain the ongoing directional move (chart 7).
So I am not really interested in the crosses lower from high stochastic
readings, or the turn higher from low levels, as these could simply
reflect a period of noise as the indicator fails to unwind over-
extended conditions as we know can often happen. Instead, what
is even more important to me is when the indicator crosses back to
the upside in a bullish trend (or to the downside in a bearish one),
which signals that the correction against the main trend is ending,
and the original directional move is about to be re-established, thus
presenting a strong buy/sell signal.
Trending
In theory, it should be easy to tell if a market is trending bullish or
bearish, but thats not always the case. To help establish where
risks lie, a number of trending-based indicators are available to the
technician. In my opinion, the best for ease of use and confirmation of
the directional trend is Moving Average Convergence Divergence
indicator (MACD). Used alongside the stochastic momentum, the
MACD can provide some very useful signals.
MACD Trending Indicator
This indicator measures the gap between a short-term and a
longer term (I use 10- and 20-day) exponential moving averages,
and delivers an indicator line (the blue line on Chart 8) together
with a 3-day average of the indicator itself (the red line on Chart
8). As prices move aggressively in one direction or the other, the
10-day average will follow action much faster than will the 20-day,
so the gap between the two averages widens.
Some use the MACD in a similar manner to the stochastic; a cross
lower from overbought readings is a sell, while a cross higher
against oversold conditions is a buy. I find this difficult, as any
moving average based indicator is lagging, so price movement is
required to actually see a signal. Therefore, So while the MACD
can be useful, it is often late, hence I tend to use crosses in the
MACD as confirmation signals, preferring to use the MACD indicator
more to signal the direction of the main trend. So if the MACD is
>zero the market is in a bullish trend; if its <zero, the market is
trending bearish.
Momentum/Trending Relationship
Thus, we have an indicator that gives good directional signals but
lags market movement, taking time to turn higher or lower (the
MACD) and one that is not always reliable at highlighting
overbought/oversold signals, but shows when a consolidation has
ended and the directional trend set to be established again (the
stochastic). What if we combine the two; maybe the problems of
each will cancel out.
So we use the MACD to confirm in which direction the market is
trading (any cross from negative to positive will give a buy signal,
and from positive to negative a sell signal) and the Stochastic to
time when consolidations are over (if momentum turns higher
with the MACD >zero its a buy signal, or lower with the MACD
<zero, its a sell). In other wordswe are buying when momentum
turns up in a bullish trend and selling when it turns down in a bearish
one, which I believe are the strongest and most reliable technical
signals we can see.
Lets look at Chart 9 (below) in closer detail. The important thing
Chart 7: The Problem with Momentum Indicators (in this case Stochastics)
Chart 8: The MACD Indicator Signals Can be Lagging
Chart 9: Buy and Sell Signals Using the Momentum/Trending Relationship
MARKET TECHNICIAN Issue 58 March 2007 12
to remember in using the momentum/trending relationship is
that if Stochastics cross, we filter it against the MACD. If
momentum crosses down and the trending tool is >zero we
ignore the signal completely; if the MACD is <zero its a new sell
signal (red arrows on Chart 9). On the flip side, if the stochastic
crosses up with the MACD <zero that is ignored, but if the
trending indicator is >zero, its a buy signal (blue arrows on
Chart 9). The brown arrows highlight when the MACD crossed its
own moving average to confirm a similar turn in stochastics (in
other words, when we have both momentum and trending
measures highlighting the risk of a more extended
consolidation/recovery phase). In this situation, we do not want
to hold risk, and sell all positions, waiting to see how the
situation develops. Either the MACD will cross zero to give us a
signal, or stochastics will be crossing up or down (confirmed by
the MACD being > or < zero) to highlight that the directional
trend is about to resume.
December 2006 - January 2007 was a very interesting phase for
markets, with prices under significant pressure for no obvious
fundamental reason. Using the momentum/trending relationship,
we actually saw our combined approach give some strong
signals.
The three long recommendations seen during the late
October/early November 2006 consolidation period (the last 3
blue arrows on chart 9 when the MACD crossed >zero on Oct
31
st
followed by Stochastics crossing higher on Nov 10
th
and
Nov 21
st
) were closed when the stochastic cross was confirmed
by a turn lower in the MACD on Dec 7
th
2006, we had the
indication that a more extended consolidation/correction was
about to occur, so we closed the long recommendations. We
didnt recommend shorts, since we didnt know at the time if the
correction would be limited before the up trend extended again
(signalled by momentum crossing up with the MACD >zero) or a
new downtrend was about to develop, reflected by the MACD
closing <zero, to give us a new shorting signal on December
18
th
at 108.12). Subsequent bounces in price prompted the
stochastic to cross higher, but without these confirmed by the
MACD (which continued to fall <zero), each following cross lower
in momentum gave us the signal to add to short
recommendations on Dec 22
nd
at 108.05; Jan 11
th
at 107.10;
Jan 23
rd
at 106.285 - as we were confident each time the
downtrend would continue having seen momentum turn bearish
again within a downtrend. We established a total of 4 short
recommendations within that particular sell-off, only closing all
positions on February 1
st
2007 at 106.215, when the MACD
finally crossed above its own moving average, following the
stochastic signal seen earlier on January 30
th
.
The idea behind the momentum/trending relationship is that it keeps
you in a position and adds to it even though momentum can be at
overbought or oversold readings. We all tend to question how
sustainable a move will be, on the ill-conceived perception that
overbought prices means strength cant continue, and oversold
prices highlight that selling pressure will end and a rally is about
to occur. But this just simply is not the case. By following these
type of signals highlighted in the table below, we can still add to
positions when we have confirmation that the trend will continue,
even though prices are over-extended, and when to stand aside
and close all positions because we simply dont know how long a
consolidation is going to take, or if it is going to turn into a trend
reversal.
Signal Action
MACD closes >zero BUY signal
Stochastic crosses down with MACD >zero Do nothing
Stochastic crosses up with MACD >zero BUY signal
MACD crosses down with stochastic falling CLOSE all positions
MACD closes <zero SELL signal
Stochastic crosses up with MACD <zero Do nothing
Stochastic crosses down with MACD <zero SELL signal
MACD crosses up with stochastic rising CLOSE all positions
Dont forget that any indicator is a derivative of price and so I use
Candlestick analysis alongside the momentum/trending relationship.
As such, a candlestick reversal outweighs momentum/trending
conditions. By that, I mean that if a bearish engulfing pattern is
formed and confirmed, I would reverse long positions to go short,
even if momentum is rising at the same time, as trending tools are
bullish. The sentiment change reflected by the reversal will be
mirrored, in time, by the indicators.
Summary
There is a confusing array of technical tools and techniques
widely used within the market these days. Most are very
successful, but at the end of the day, it is the investors
responsibility to assess what suits his trading style and what can
be trusted to deliver the type of signals to follow with confidence.
I have found that a consistent approach combining sentiment
measures with momentum and trending tools can help establish
the trend direction, when to add risk within that trend, and when
to reduce exposure and actually sit on the sidelines because I
simply dont know which way the market is going. In that latter
situation, I would rather wait for confirmed signals than make a
coin toss (50/50) call.
Richard Adcock, Director Fixed Income Technical Strategy, UBS
Investment
1
Japanese Candlestick Charting Techniques: A Contemporary Guide to the
Ancient Investment Techniques of the Far East, by Steve Nison (who is widely
considered the expert on candlestick charting in the Western world).
2
George Lane is known as the Father of Stochastics for his work on the
stochastic oscillator.
ANY QUERIES
For any queries about joining the Society, attending one of the STA courses
on technical analysis or taking the diploma examination, please contact:
STA Administration Services (Katie Abberton)
Dean House, Vernham Dean, Hampshire SP11 0LA
Tel: 07000 710207 Fax: 07000 710208 www.sta-uk.org
For information about advertising in the journal, please contact:
Deborah Owen,
PO Box 37389, London N1 OES Tel: 020-7278 4605