Winter 2000

Table of Contents

Journal Editor & Reviewers Go
1
PREDICTING RANK ORDER STOCK PRICE PERFORMANCE USING A MULTI-
FACTOR RELATIVE PRICE STRENGTH MODEL Frederic H. Dickson, CMT
Go
2
SCIENCE IS VALIDATING THE CONCEPT OF THE WAVE PRINCIPLE Robert R.
Prechter, Jr., CMT
Go
3
THE INTERACTION OF TRENDINESS MEASURES AND TECHNICAL
INDICATORS Basil Panas, CFA, CPA, CMT
Go
4
HEAD AND SHOULDERS ACCURACIES AND HOW TO TRADE THEM Serge
Laedermann
Go
5
VOLATILITY AND STRUCTURE: BUILDING BLOCKS OF CLASSICAL CHART
PATTERN ANALYSIS Daniel L. Chesler, CTA, CMT
Go


Journal Editor & Reviewers
Editor
Henry 0. Pruden, Ph.D. Golden Gate University San Francisco, Calijinnia
Associate Editor
David L. Upshaw, CFA, CMT Lake Quivira, Kansas
Jeffrey Morton, M.D. PRISM Trading Advisors Missouri City, Texas
Connie Brown,
CMT Aerodynamic
Investments Inc. Pawlqs
Manuscript Reviewers
Charles D. Kirkpatrick, II,
CMT Kirkpatrick and Company, Inc.
Michael J. Moody, CMT Dory,
Wtigh t & Associates
Pasadena, Calijornia
Island, South Carolina
John A. Carder, CMT Topline
Investment Graphics Boulder,
Colorado
Ann F. Cody, CFA Hilliard
Lyons Louisville, Kentucky
Robert B. Peirce Cookson,
Peirce & Co., Inc. Pittsburgh,
Penns$vania
Chatham, Massachusetts
John McGinley, CMT Technical Trends
Wilton, Connecticut
Cornelius Luca Bridge Information
Systems New Ymk, New Yorlz
Theodore E. Loud, CMT Tel Advisor
Inc. of Virginia Charlottesville, Virginia
Richard C. Orr, Ph.D. ROME
Partners Marbtehead,
Massachusetts
Kenneth G. Tower, CMT UST
Securities Princeton, New
Jersey
J. Adrian Trezise, M. App.
SC. (II)Consultant toJ.P
Morgan London, England
Production Coordinator
Barbara I. Gomperts Financial & Investment
Graphic Design Marblehead, Massachusetts
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1: PREDICTING RANK ORDER STOCK PRICE PERFORMANCE USING A MULTI-
FACTOR RELATIVE PRICE STRENGTH MODEL
Frederic H. Dickson, CMT
INTRODUCTION
One of the greatest challenges facing equity investors is predicting individual stocks relative future
price performance in a manner that is disciplined, can be easily replicated and produces consistently
accurate results over the investment time horizon of interest to the user.
As Research Director of a regional brokerage firm, I am continually asked to offer an opinion
regarding the future price performance of specific stocks relative to a specific universe or specific
portfolio. To meet this challenge, I have constructed and currently maintain and electronically
distribute an extensive equity database. Updated weekly, this database includes a wide variety of
technical and fundamental indicators and several forecasting models, including a short-term,
technically-based, relative strength momentum model designed to provide relative performance
guidance over a three to six-month time horizon.
Currently there is no shortage of proprietary and publicly available research tools attempting to
accomplish this objective. In the authors opinion, there does exist a noticeable absence of published
data evaluating how well these tools work after-the-fact, assuming multiple start and end dates. We
continue to observe that most published test results are derived from back-testing procedures
assuming a single start and end date for the test. A potential user of the indicator is often at a loss to
determine if encouraging results are the product of a model that has consistent forecasting ability or
merely a coincidentally favorable test period.
Finally, the prospective user of a forecasting or relative ranking system often has no idea of how long
the projected rankings will provide predictive value before deteriorating, or the consistency of a
ranking methodology in accurately predicting the rank order of investment results for a significant
equity universe under consideration. Results are often reported from universe subsets that will
provide encouraging results. In summary, we have typically found the absence of data on the
pervasiveness and consistency of test results generated by systems employed live or after-the-fact
to be very troubling.
OVERVIEW AND CONCLUSIONS
This paper describes and presents the results of a technically based, multifactor stock selection and
ranking index (momentum index) research methodology. The results presented are based on an ex
post facto analysis of actual predicted and published rank performance suggested by the index. The
rankings have been published weekly as part of the Branch Cabell Equity Advantage Database since
June 25, 1999. The test analysis extends from the initial index publication date ofJune 25,1999
through November 26, 1999. The testing protocol considers the performance of the index assuming
multiple overlapping start and end dates (of variable length holding periods) during this time period.
As described below, the initial test results are encouraging, as the model appears to have provided
positive predictive value over a wide variety of holding periods as determined using several rigorous
academically acceptable evaluation criteria.
The momentum index in Chart 1 below shows the rank of an individual stock relative to its selection
universe based on combining two ranked measures of cycle position for each stock and three ranked
measures of price change.
Our investment hypothesis is that the Branch Cabell momentum index can demonstrate consistent
predictive rank order performance results in excess of those generated from investing in a market
(S&P 500) index fund over various weekly holding periods after making appropriate adjustments for
historical price risk.
The momentum index was initially created to help investors assess probable three to six month rank
order price for a 1,750 com pany equity universe including approximately 100 listed ADRs. The debut
of this indicator was June 25,1999. As shown in Chart 1, the S&P 500 experienced two corrections
and recoveries of at least five percent between July 1999 and November 26,1999. Looking back, this
introductory five-month period was extremely trying for most investors as well as being a very diflicult
period to test and evaluate any technically-based stock selection methodology due to the number
and magnitude of the market and individual stock price directional changes. Over the entire time
period, the S&P 500 was up 6.5% and the average price change of stocks included in the test
universe was down 2%:

For testing purposes, we assumed an equal dollar-weighted investment in each name in the universe
each week. We then divided the universe into deciles based on the ranking suggested by the
momentum index and measured the performance of each ranking decile weekly over various holding
periods during the test period. This procedure eliminated the possibility of favorable start and end
dates impacting the test results. Although five months of test data is a very short time frame to
evaluate an index and to conclude the validity of our investment hypothesis, we believe the following
initial observations are noteworthy and justify continued publication of the index and the indefinite
extension of the testing procedure.

1. The momentum index successfully projected rank-order performance over 20 overlapping
time periods (extending from l-20 weeks) based on multiple start and end dates evaluated
between June 25, 1999 and November 26, 1999 (Table 1). The results were pervasive and
surprisingly consistent over the range of multi-week holding periods. The correlation
coefficients of the momentum index ranked order performance ranged between 0.75 and
0.89 (1.0 marks perfect correlation, 0.0 marks zero correlation and -1.0 marks perfect
negative correlation) for all time periods tested.
2. The absolute returns also initially suggest a high degree of rankorder forecasting ability. For
all periods tested, the absolute return of stocks ranked in the top decile ranking was greater
than the returns produced by stocks in the second decile (See Chart 3). Stocks ranked in
the 2nd decile in turn outperformed stocks ranked in the 5th decile then in turn outperformed
stocks ranked in the last (10th) decile. The degree of outperformance between the stocks in
the top ranked decile and bottom ranked decile ranged from an average of 2.3% for a l-
week holding period to 19.4% for a IO-week holding period and 40.3% for a 20-week
holding period. The spread of rank order returns are highly significant when compared to the
distribution of returns generated from a random selection of stocks made from the same
universe tested in a similar manner over the same time period (Table 2). The top decile of
stocks selected randomly underperformed the bottom ranked decile by 0.3% for one week,
out erformed by 0.08% at 10 weeks and underperformed by 1.17 o at 20 weeks. ?
3. Stocks identified in the top two ranked deciles produced positive risk-adjusted excess
returns for all time periods up to 17 weeks when evaluated using the Jensen Modified
Capital Asset Pricing model (Table 3). The results were dramatically above what a rational
investor would expect based on the risk profile of the stocks included in each decile
category. Stocks included in the bottom two ranked deciles consistently produced the
poorest negative excess returns over the entire spectrum of holding period.
4. The momentum rankings index produced excess returns consistent with their decile position
rather than the average beta associated with each decile ranking position. These results
were inconsistent with what one would expect based on the volatility assigned to each
decile ranking class based on historical betas. This apparent market anomaly is worth
noting and strongly suggests that future tests be conducted to determine the extent and
pervasiveness of this anomaly over longer time periods including a full market and
economic cycle.


5. We expected the average volatility, as measured by beta, for the stocks in each momentum
index decile to decline proportionately by decile ranking category. We expected the highest
momentum index ranked stocks to have the highest average historical beta and the lowest
ranked stocks to have the lowest historical beta. In fact, the observed average beta declines
sequentially as expected between decile ranks 1 and 5 but then unexpectedly rises
sequentially between decile ranks 6 and 10 (Table 3).
6. The average beta measured over the entire 20-week time horizon within specific momentum
ranking deciles was not stable (Table 4). During one period of sustained market weakness,
(July 16July 30) the average beta of the top decile momentum ranked stocks fell from 1.38
to 1.15 while the beta of the lowest momentum ranked stocks rose from 1.04 to 1.20. The
average beta of the middle-ranked decile remained very stable throughout the entire test
period. The unusual variability could possibly be attributed to stocks eliminated from the
universe during the testing period that were replaced by stocks with substantially different
volatility characteristics.
7. We expected the momentum index to demonstrate proportionately reduced forecasting
ability as the holding period lengthened. The test data suggests that the momentum indexs
ability to produce returns consistent with the rankings persists much longer than we
originally expected. Although we have only a few data points for holding periods beyond 15
weeks, the rank order correlation coefficients remain very high (0.80) with little noticeable
deterioration beyond this time horizon. The positive spread of realized returns between
performance ranks remains intact from the highest decile to the lowest decile for all periods
up to 20 weeks. For this limited testing period, the momentum index met our initial objective
of pervasiveness by maintaining its discrimination ability across the stock universe for time
periods in excess of 13 weeks.
8. We observed significant deviation of returns for the individual stocks included within each of
the decile rankings. The performance statistics of individual stocks suggest the widest
dispersion of individual stock returns at the highest and lowest decile ranking levels.
Therefore, one needs to look at the decile performance rankings as only an indication of
central tendency for the stocks included in each decile rather than an absolute predictor of
future individual stock performance. The performance ranks suggest probability of
performance rather than serving as an explicit predictor of performance on a stock-by-stock
basis.
9. We conclude that for the time period tested, the momentum index provided valuable
forecasting information about the future risk-adjusted excess returns that could be profitably
exploited by investors after considering reasonable transaction costs. An investor could
have begun to employ the published momentum index rankings several weeks after the
testing period began and would have received approximately the same benefit as an
investor who employed the model from the start of the test period over the entire array of
holding periods. The results appear to be consistent and pervasive during the test period
across holding periods ranging from one to twenty weeks.
METHODOLOGY The Momentum Ranking Index
Background. The genesis of the authors interest in relative strength analysis dates back over 30
years. In his 1967 doctoral thesis, Dr. Robert A. Levy scientifically explored and tested a 26 week
relative strength ranking system that he claimed invalidated the widely accepted weak efftcient
market thesis. Several academic researchers at the time concluded that Dr. Levys ability to
demonstrate exceptional performance results was a direct function of the volatility inherent in the
stocks selected rather than a persistent market anomaly. Thus, Dr. Levys claim of refuting the
efficient market hypothesis was widely discredited. On a practical basis, we have found the original
26week rate of change indicator to be helpful in establishing probabilities of future results, but lacking
persistence and consistency when applied across a wide universe of stocks.
Index definition and construction. The momentum ranking index is constructed using only historical
price behavior of individual stocks. Thus, it is a pure technical index. Conceptually, the index
attempts to quantify a stocks position within a 52-week price cycle and its momentum or rate of
change as measured over 4week, 13-week and 52-week periods. The momentum ranking index
subcomponents, cycle position and velocity (percent price change) appear to be greatly impacted by
overall market factors. The ability of the stock to respond to changing market factors is hypothesized
to be a critical variable in determining near-term price changes. This index has been continuously
constructed on a weekly basis since June 25,1999. No changes were made in construction
methodology during the test period.
Each week every stock in the 1,750 company universe is ranked relative to the entire universe based
on its respective Price/52-week high and Price/52-week low to determine relative cycle position. Then
each stock is separately ranked on the basis of its 4week, 13 week and 26week price change relative
to the same universe. Each stocks ranked position based on each of these five criteria are then
summed and ranked relative to each stock in the universe to determine the final technical momentum
ranking index. A stock ranking number 1 in each category would have a composite score of 5. This
score would be compared to the scores of all other companies in the universe to determine a final
momentum index rank. The stock with the lowest cross-ranked score is projected to have the highest
probability of outperforming all other stocks in the universe going forward (See Chart 1).
During the testing period, approximately 75 companies from the original starting universe were
eliminated from the universe due to mergers or acquisitions. New companies were introduced into
the universe during the test period at the request of our retail clients, our institutional brokerage
clients or to include IPOs of technical or fundamental interest when data became available on the
StockVal database. For companies with less than 52 weeks of pricing data, we calculated
comparable cycle position statistics using Price/Life of Company high price in place of the Price/52
week high ratio and Price/Life of Company low price in place of the Price/52-week low ratio. For
companies with fewer than 13 weeks of pricing data, we substituted the price change from the
companys IPO to the calculation date for the index in the velocity indicators. We have not identified
the impact of these changes on the test results shown in this paper.
The momentum index is calculated based on Friday closing prices (4:30 PM EST/EDT) and does not
recognize prices posted in Friday aftermarket trading on electronic exchanges such as Instinet. The
historical prices in the database are adjusted when a stock split or meaningful stock dividend occurs.
Companies that have been acquired during the test period are purged from the universe to preserve
comparability of companies from each weekly starting point. This adjustment might add a small
positive or negative bias to the test results.
Testing Procedure
Test period. The test period was conducted between June 25, 1999 and November 26, 1999 using
the technical momentum index published weekly in the Branch Cabell Equity Advantage Database
between June 25,1999 and November 5,1999. June 25,1999 marked the first date the Technical
Momentum Index was pub lished and distributed to clients.
Stock Universe. The Equity Advantage Stock universe was originally constructed in October 1998. It
includes members of the S&P 500, the Russell 1000, selected holdings or stocks of special interest
to clients of Branch Cabell, and stocks covered by CS First Boston and Prudential Research
(research correspondents of Branch Cabell). Stocks not otherwise identified with at least $1 billion in
market capitalization are also included in the database. The performance of the Branch Cabell Equity
Universe versus the S&P 500 is shown in Chart 2. The stocks included in the universe are included in
the StockVal database which is used as the basic information source for all data. Friday night
closing prices are downloaded from the StockVal database and loaded into the Branch Cabell Equity
Advantage database every Saturday. StockVal provides component calculations for the five
variables included in the Technical Momentum Index.
Testing Protocol. Each week the technical momentum ranks and individual equity betas were loaded
into an Excel spreadsheet along with the model ranking algorithms. Historical weekly prices were
retrieved from the StockVal database for each worksheet, providing the necessary data to calculate
cumulative weekly returns from the initial date of the holding period to the last date included in the
test (November 26, 1999). The stock prices were split-adjusted but were not adjusted for spinoffs that
may have negatively impacted the performance of a specific stock. Each weekly database was then
sorted in ascending order of technical momentum rank, with most favorable momentum rank at the
top of the list and least favorable at the bottom of the list. The universe was then divided into deciles,
and average performance returns were calculated for each performance decile. The data were
ordered so that the average performance of comparable weekly holding periods could be determined.
The procedure was repeated for each of the twenty weeks included in the test. The results were
averaged for each ranking decile by comparable holding periods. Thus one could easily evaluate the
returns for all l-week, 5-week, lo-week, etc. holding periods on a common basis.
This procedure allows us to draw conclusions about the persistence and consistency of the
performance ranking results without assuming specific starting and ending test period dates. We view
this as a very rigorous but fair testing protocol. The results of this protocol are shown in Table 1.
Chart 3 presents a graph of the test results over the test period. After 20 weeks, initial signs of conver
gence between the performance of the bottom decile and the middle decile ranking position were
beginning to appear, although the number of data points observed remain very small (3). The spread
between the top decile ranking position and the middle decile ranking position continued to widen.
Mindful of the weak efficient market hypothesis which suggests that purely historical stock price
behavior has no predictive power, we decided to construct a benchmark test assigning random
numbers as a pseudo technical momentum rank, or pseudo ranks. Using the Excel worksheets
random number function, a number between 0 and 1 was generated and multiplied by the universe
size to determine a stocks pseudo rank. Stock performance tests were then conducted in a manner
consistent with the test procedure used to determine the performance of the technical momentum
ranks. The data from this test is shown in Table 2. The randomly generated performance ranks
produced apparently random results within very tight performance boundaries. The re sults of the
pseudo ranking test provide a benchmark in order to evaluate whether our technical momentum
model was the product of a random process or identified a market anomaly that can be exploited by
investors. Performance that substantially exceeded the randomly generated results, particularly at
the decile rank ex tremes, added confidence in the validity of the momentum index test results.
A comparison of the performance of the technical momentum ranks versus the pseudo ranks
strongly suggests that the predictive performance of the technical momentum rank was the result of a
process other than chance. We draw the same conclusion evaluating the average rank order
correlation coefftcients of the technical momentum ranks (consistently above 0.75 with 99% of the
observed individual cell rankings above 0.1) versus the correlation coefficients produced by the
pseudo ranks. As expected and shown in Chart 3, the performance spread between the decile
rankings for the pseudo ranks was very narrow and the decile performance showed a high
tendency for convergence.
Cognizant of the academic arguments raised in the challenge of Dr. Levys study, we then
constructed a matrix that identified the betas associated with the stocks grouped into the decile
categories by their technical momentum rank. Table Four presents this data. The betas shown were
calculated as of September 30, 1999. It was not practical to recreate the betas for June 25, 1999.
Our assumption is that the change in betas on a stock-by-stock basis would be minor, as the beta
calculation was made based on five years of weekly price data for each stock and for the S&P 500.
The data provided an interesting twist. We expected to see rank order correlation between the betas
for each decile and the momentum index decile rankings. This would indicate that the stocks with the
highest estimated technical momentum would have the highest betas and those with the lowest
technical momentum would have the lowest betas. The data did not confirm this hypothesis. In fact,
the data suggest a bi-modal distribution with the betas accelerating as one approaches the upper and
lower decile ranking levels. We did not expect the worst performers to have the second highest decile
beta rankings in the universe during the test period.
As a final test, we decided to compare the performance results produced by the technical momentum
rankings to those predicted by the Jensen Modified Capital Asset Pricing Model (MCPM), a
benchmark test used to determine rational asset pricing. MCPM states that an assets return is
related to the risk free rate of return plus the difference between market rate of return (S&P 500) and
the risk free rate of return times the beta of the specific security. (Expected Individual Security Return
= Risk Free Rate t (Market Return - Risk Free Rate)* Individual Security Beta). If the differential is
positive, an unexplained excess return is generated. Investors are being compensated for their
unusual investment knowledge.
Table 3 presents the excess returns generated using the momentum rankings by decile over the test
period, assuming various holding periods and starting dates. The theory behind the MCPM assumes
that the return of the asset category will be a direct function of the asset categorys volatility as
measured by beta. The data shown below contradict that conclusion. The excess returns
systematically decreased in direct proportion to the rank ordered position of the index in contradiction
to the directional movement of the average beta by decile position. This anomaly is certainly worth
exploring in more depth in the future as the momentum index gains more ex post facto history.
Our hunch is that the anomaly partially reflects the fact that the measurement period of the
performance data is far shorter than the time period used to calculate each individual stocks beta.
We believe betas calculated for a time period consistent in length with the test period could have
produced far different and more predictable results consistent with that expected using the MCPM.
Thus, we cannot make a strong assertion about the validity of the Capital Asset Pricing Model when
evaluated from the perspective of this test protocol. The data do suggest that the technical price
momentum model successfully discriminated future price performance on a rank-order risk-adjusted
basis during the test period.
FINAL OBSFRVATIONS
The findings of this study are highly encouraging. The results suggest that momentum as a market
behavior force was much more pervasive than we previously expected. Clearly, this is an investment
style employed by enough participants in the market place to impact security pricing behavior. We
will continue to capture, test and evaluate future results using the ability of the momentum index
rankings to predict rank order stock performance behavior over varying time horizons. In the future,
we plan to evaluate the performance of the technical momentum performance ranks on the basis of
market capitalization to determine if there is any small or large cap bias and in combination with our
fundamentally based indicators. Our goal is to understand how well our published indicators work,
why they work, to identify forecasting problems if and when they occur and to encourage other
practicing technical analysts to adapt a similar rigorous approach to testing the validity of their model
forecast on an ex-post-facto basis.



REFERENCES
Robert A. Levy, Random Walks, Realty or Myth, Financial AnalystsJouma1 (November-
December 1967a).
Michael C. Jensen and George A. Bennington, Random Walks and Technical Theories:
Some Additional Evidence, The Journal ofFinance, XXV, No. 2 (May 1970).




BIOGRAPHY
Frederic H. Dickson, CMT is Managing Director of Research at Branch Cabell & Co., Inc., in
Richmond, VA. Fred is a past President of the Market Technicians Association (1983 1984), served
for many years as the Educational Committee Chairman of the MTA and authored the first set of test
questions selected for use in the CMT Level I examination. Fred has served as an Adjunct Assistant
Professor of Finance at the University of Richmond and as an Instructor at the New York Institute of
Finance. He has contributed several articles in the past to the MTA Journal. He presently publishes a
daily and weekly market comment and the Branch Cabell Equity Advantage Database for an
institutional audience.

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2: SCIENCE IS VALIDATING THE CONCEPT OF THE WAVE PRINCIPLE
Robert R. Prechter, Jr., CMT
New discoveries in the field of complexity theory, fractal geometry, biology and psychology are
rapidly yielding more knowledge bolstering the probability that the Wave Principle is a correct
description of financial and social reality. This report provides a cursory overview of some of these
advances.
To understand the connection between todays scientific discoveries and the Wave Principle, it is
necessary to describe it in modern terms. In the 1930s Ralph Nelson Elliott (1871-1948), through
extensive empirical observation, discovered that price changes in stock market indexes produce a
limited number of definable patterns (called waves) that are variably self-affine at different
degrees, or sizes, of trend. As opposed to self-identical fractals, whose parts are precisely the same
as the whole except for size (see example in Figure l), and indefinite fractals, which are self-similar
only in that they are similarly irregular at all scales (see example in Figure 2), Elliott proposed a
model of intermediate specificity. Though variable, its component forms, within a defined latitude, are
replicas of the larger forms. Waves have event-specific relutiue quantitative properties, as do self-
identical fractals, but they are unrestricted in absolute quantitative terms, like indefinite fractals. The
fact that both waves and (as we shall soon see) natural branching systems are fractals of
intermediate specificity implies that nature uses this fractal style to pattern systems that require
highly adap tive variability in order to flourish. Therefore, I think the best term for this variety of fractal
is robust fractal. As we shall see, this is a form that living structures typically display.
The essential form of the Wave Principle is five waves generating net progress in the direction of the
one larger trend followed by three waves generating net regress against it, producing a three-steps-
forward, hvo-steps-back form of net progress. The 5-3 pattern is the minimum requirement for, and
therefore the most efficient method of, achieving both fluctuation and progress in linear movement.
Elliott described how waves at each degree become the components of waves of the next higher
degree, and so on, producing a structured progression, as illustrated in Figure 3. The word degree
has a specific meaning and does not mean scale. Component waves vary in size, but it always
takes a certain number of them to create a wave of the next higher degree. Thus, each degree is
identifiable in terms of its relationship to higher and lower degrees This is unlike the infinite scaling
relating to clouds or seacoasts and unlike the discrete scale invariance? of simple fractals created by
recursive interpolation such as the snowflake in Figure 1. By incorporating features of both, Elliott
described a third type of fractal, which we will shortly explore.
Benoit Mandelbrot, an IBM researcher and former professor at Harvard, Yale and the Einstein
College of Medicine, did pioneering work bringing to light the fact that fractals are everywhere in
nature.3 The term nature in this context includes the activities of man, as Mandelbrot began by
studying cotton prices and most recently presented a multifractal model of the stock market. This
excerpt from a 1985 article in The Neu York i%res summarizes his exposition on the subject of
financial fractals:
Daily fluctuations are treated [by economists] one way, while the great changes that bring prosperity
or depression are



This is also what R.N. Elliott said about the stock market sixty years ago. Some members of the
scientific community have recently recognized the connection. Three physicists researched the stock
markets log-periodic structures and concluded that R.N. Elliotts model of financial behavior fits their
findings. In 1996, Frances Journal of Physics published the study, Stock Market Crashes,
Precursors and Replicas by Didier Sornette and Anders Johansen, then of the Laboratoire de
Physique de la Matiere Condensee at the University of Nice, France, and collaborator Jean-Phillippe
Bouchaud. The authors make this statement:
It is intriguing that the log-periodic structures documented here bear some similarity with the Elliott
waves of technical analysis [citation EZliott WavePtincipk Frost & Prechter] Technical analysis in
finance can be broadly defined as the study of financial markets, mainly using graphs of stock prices
as a function of time, in the goal of predicting future trends. A lot of effort has been developed in
finance both by academic and trading institutions and more recently by physicists (using some of
their statistical tools developed to deal with complex times series) to analyze past data to get
information on the future. The Elliott wave technique is probably the most famous in this field. We
speculate that the Elliott waves . . . could be a signature of an underlying critical structure of the
stock market.
Mandelbrots work supports this conclusion. For example, every aspect of Mandelbrots general
model, as presented in Scientific Am&an,* fits Elliotts specific model, and no aspect of Mandelbrots
general model contradicts Elliotts specific model. Mandelbrots work in this regard should properly
be seen as compatible with, and therefore support for, Elliotts more comprehensive hypothesis of
financial market behavior. We must also concede the possibility that Elliotts specific model will be
proven false and that financial markets will ultimately be shown to be indefinite fractals, which is as
far as Mandelbrots work goes. At minimum, though, it may be said that Mandelbrots studies are
among a number of modem discoveries that increase the probability that RN. Elliotts fractal model of
financial markets is true.
A year after this study (one hopes that it was not in response to it), Mandelbrot published a brief
dismissal of Elliott and his work, deriding his predecessor and taking credit for modeling the stock
market as a multifractal. (See Prechters Response of Mandelbrots Dismissal of Elliott at
www.elliottwave.com/response.htm) Advocates of the Wave Principle are not particularly interested
in this controversy per se but in the far more important fact that a renowned scientist has decided
that at least one implication of Elliotts work is so impwtant that he wants creditfm it. Whether that
credit is to be taken properly or otherwise is a question for the scientific community to decide, but the
key point is that this very situation is yet another fact that increases the potential validity of the Wave
Principle hypothesis.
THE ROBUST FRACTAL
It is imperative to understand that R.N. Elliott went fur beyond the comparatively simple idea that
financial prices form an indefinite multifractal. One of his big achievements was discovering specific
component patterns within the overall form.g Until very recently, it has been generally presumed that
there are two types of self-similar forms in nature: (1) self-identical fractals, whose parts are
precisely the same as the whole, and (2) indefinitefractalr, which are self-similar only in that they are
similarly irregular at all scales. (See Figures 1 and 2.) The literature on natural fractals concludes
that nature most commonly produces indefinite fractal forms that are orderly only in the extent of
their discontinuity at different scales and otherwise disorderly. Scientific descriptions of natural
fractals detail no specific patterns composing such forms. Seacoasts are just Yjagged lines, trees
are composed simply of branches. rivers but meander, and heartbeats and earthquakes are merely
events that differ in frequency. Likewise, financial markets are considered to be self-similarly
discontinuous in the relative sizes and frequencies of trend reversals yet otherwise randomly
patterned. These conclusions may be due to a shortfall in empirical study rather than a scientific fact.



R.N. Elliott described for financial markets a third type of self-similarity. By meticulously studying the
natural world of social man in the form of graphs of stock market prices, Elliott found that there are
specific patterns to the stock market fractal that are nevertheless high3 variable within a certain
definable latitude. In other words, some aspects of their form are constant and others are vatiabG If
this is true, then financial markets, and by extension, social systems in general, are not vague,
indefinite fractals. Camp+ nent patterns do not simply display discontinuity similar to that of larger
patterns, but th f&m, with a certain latitude, r@icas of them. Elliott defined waves in terms of those
aspects that make them identical, thereby allowing for their variability in other aspects of detail within
the scope of those definitions. He was even able to define some of the patterns variable
characteristics in probabilistic terms.
Elliotts discovery of degrees in pattern formation, i.e., that a certain number of waves of one degree
are required to make up a wave of the next higher degree, is vitally important because it links the
building-block property of self-identicalfractals to the Uave Principle, revealing an aspect of self-
identity among waves that indefinite fractals do not possess.
Elliotts discovery of specific hierarchical patterning in the stock market is fundamental. Fractality
alone is only a vague comment about that form. Zfpou can describe the pattern, you haue the
essence of the object. The more meticulously you can describe the pattern, the closer you get to
knowing what it is.
Although Elliott came to his conclusions fifty years before the new science of fractals blossomed, the
very idea that financial markets comprise specific forms and identical (within the scope of their
definitions) component forms remains a revolutionary observation because, to this day, it has eluded
other financial market researchers and chaos scientists. Elliotts work shows that the general
relationship between sizes and frequencies of financial movements, currently considered a
breakthrough discovery, is not the essence, but a by-product, of the fundamentals of financial market
patterns.
A group of scientists (see below) has very recently recognized that there is a type of fractal in nature
whose self-similarity is intermediate between identical and indefinite. As far as I know, theirs is the
only published study on the subject. Before we discuss this new aspect of Wave Principle validation,
we first must detour through another of R.N. Elliotts discoveries and understand how it contributes to
his grand hypothesis.
THE ROLE OF FIBONACCI IN ROBUST FRACTAIS
Because the essential form of the wave Principles is a repeated 5-3, the numbers of waves at
different degrees reflect the Fibonacci sequence. The Fibonacci sequence is 1, 1, 2, 3,5, 8, 13, 21,
34, 55, and so on. It begins with the number 1, and each new term from there is the sum of the
previous two. The limit ratio between the terms is .618034..., an irrational number sometimes called
the golden mean but in this century more succinctly phi (4).
The simplest expression of a falling wave is 1 straight-line decline. The simplest expression of a
rising wave is 1 straight-line advance. A complete cycle is 2 lines. At the next degree of complexity,
the corresponding numbers are 3,5 and 8 (see Figure 4). This Fibonacci sequence continues to
infinity.
Both the Fibonacci sequence and the Fibonacci ratio appear ubiquitously in natural forms ranging
from the geometry of the DNA molecule to the physiology of plants and animals. Figures 5 and 6
show examples. (For more, see Chapters 3 and 11 in The Wave Principle of Human Social
Behavior.) In the past few years, science has taken a quantum leap in knowledge concerning the
universal appearance and fundamental importance of Fibonacci mathematics to nature. Uithout the
benefit of that knowledge, after researching the subject to the small extent possible at the time, Elliott
presented the final unifying conclusion of his theory in 1940, explaining that the progress of waves
is governed by a mathematical principle that governs so many phenomena of life. From this ob
servation, he concluded that the progress of mankind is the same type of growth process that we
see in so many instances throughout nature.
Modern science is catching up to R.N. Elliott. In 1993, five scientists from the Centre de Recherche
Paul Pascal and the Ecole Normale Supeieure in France investigated the diffusion-limited
aggregation (DLA) model, which is a set that diffuses via smaller and smaller branches, just like the
branching fractals found in nature, such as the circulatory system, bronchial system and trees.
Arneodo et al. state at the outset that it is an open question whether or not some structural order is
hidden in the apparently disodered DLA morphology. To investigate the question, they use a
wavelet transform microscope to examine the intricate fractal geometry of large-mass off-latice DLA
clusers. (See Figure 7)



What mathematics govern this robust fractal? In the first linking (as far as I can discover) of the two
concepts of fractals and Fibonacci since Elliott, they demonstrate that their research reveals the
existence of Fibonacci sequences in the internal extinct region of these clusters. The authors find
that the branching characteristics of offlattice DLA clusters proceed according to the Fibonacci
recursion law, i.e., they branch in intervals to produce a l-2-35-8-13-etc. pro gression in the number
of branches. The authors of this study, then, have found the Fibonacci sequence in DLA clusters in
the samplace that RN. Elliott found the Fibonacci sequence in the Wave Princi$tz in the increasing
numbers of subdivisions as the phenomenon progresses.
The authors find even more evidence of Fibonacci. They have discovered that the most commonly
occurring screening angle between bifurcating branches of these DLA clusters is 36 degrees,
which holds regardless of scale. (See Figure 8.) This is the ruling angle of geometric phenomena
that display Fibonacci properties, from the five-pointed star (Figure 9) to Penrose tiles (Figure lo), a
robust filling of plane-space with just two rhombi. The authors elaborate:
The intimate relationship between regular pentagons and Fibonacci numbers and the golden mean 4
= 2cos(x/5) = 1.618... has been well known for a long time. The proportions of a pentagon
approximate the proportions between adjacent Fibonacci numbers; the higher the numbers are, the
more exact the approximation to the golden mean becomes. The angle defined by the sides of the
star and the regular pentagons is 6 = 36, while the ratio of their length is a Fibonacci ratio (F,+l/F,).
The authors conclude, The existence of this symmetry at all sca2RF is likely to be a clue to a
structural hierarchical fractal orderng. Indeed, it is. In a similar way, Elliott found that the price
lengths of certain waves are often related by .618, at all scales, revealing another, though perhaps
less fundamental, Fibonacci aspect of waves.
These mathematics pertain to apparently randomly branched fractals that bear a striking
resemblance to the tenuous tree-like structures observed in viscous fingering, electrodeposition,
bacterial growth and neuronal growth, which are strikinglv similar to trees, root systems, algae,
blood vessels and the bronchial architecture, i.e., the typical products of nature.
This is exciting news, but it concerns a model that looks like nature. What do we find when we
investigate the actual products of nature? We find phi again and again. In the early 196Os, Drs. E.R.
Weibel and D.M. Gomez meticulously measured the architecture of the lung (see Figure 11) and
reported that the mean ratio of short to long tube lengths for the fifth through seventh generations of
the bronchial tree is 0.62, the Fibonacci ratio.* Bruce West and Ary Goldberger have found that the
diameters of the first seven generations of the bronchial tubes in the lung decrease in Fibonacci
proportionn Oxford professor of mathematics Roger Penrose, who shared the Wolf Prize for Physics
in 1988 with cosmologist Stephen Hawking, presents this discussion of the smallest components of
our nervous system in his 1994 book, Shadows of the Mind:
The organization of mammalian microtubules is interesting from a mathematical point of view. . ..the
skew hexagonal pattern... is made up of 5 right-handed and 8 left-handed helical arrangements...
The number 13 features here in its role as the sum: 5 t 8. It is curious, also, that the double
microtubules that frequently occur seem normally to have a total of 21 columns of tubulin dimers
forming the out side boundary of the composite tube - the next Fibonacci number! [See Figures 12
and 13.1







Led by Eugene Stanley of Boston University, fifteen researchers from MIT, Harvard and elsewhere
recently studied the physiology of neurons (see Figure 14) in the central nervous system with the
goal of quantifying the arboration of the neurites, which are the arba of neurons. Taking the ganglion
cells of a cats retina as a model system, they find that the fractal dimension of the cells is 1.68-t or-
0.15using the box counting method and 1.66-t or- 0.08 using the correlation method. 15 Although
the authors do not men- tion it, this is quite close to phi. The source of all these biological structures
is DNA. Given current best measurements, the length of one DNA cycle is 34 angstroms, and its
height is 20 angstroms, very (source: http://polymm bu. edu/)



Recall that each pattern under the Wave Principle has identifiable rigidities as well as tendencies.
This is true not only of Elliott waves but of natures branching patterns. While the general assumption
has been that branching patterns are indefinite fractals, this study shows that these apparently
random fractals are in fact more orderly than previouslyrealized. Indeed, Arneodo, et al. determine
that they are working with a type of fractal that scientists had not yet found, an intermediate form
between exact self-identity and vague, indefinite self-similarity:
The intimate relationship between regular pentagons and Fibonacci numbers and the golden
mean...has been well known for a long time.... The recent discovery of quasicrystals in solid state
physics is a spectacular manifestation of this relationship. This new organization of atoms in solids,
intermediate between perfect order and di.sor&, generalizes to the crystalline forbidden
symmetries, the properties of incommensurate structures. Similarly, there is room for quasifractals
between the well-ordered fractal hierarchy of snowflakes and the disordered structure of chaotic or
random aggregates.
This is the same type of intermediately ordered fractal that R.N.Elliott described for the stock market.
I conclude from these studies and the Wave Principle that fractals that characterize natures life
forms share at least two properties: robustness (inter mediate orderliness/variability) and Fibonacci. I
prefer the term robust fractal to quasi-fractal, as its connection to natural, usually living, phenomena
indicates that there is nothing quasi about it. I believe that robustness will prove to be the essence of
fractals that matter most in nature.
CONCLUSION
The latest scientific research is racing headlong toward validating the concept of the Wave Principle,
and not just in its simple expression as a financial multifractal. It is also supporting its grander
implications that natures living fractals are robust, that they are governed by Fibonacci, that one of
them governs the entire activity of social man, and therefore that the mathematical basis of mans
sociocultural progress and of other natural growth systems is the same.
The level of aggregate stock prices is not a m _ tiqsity but a direct and immediate measure of the
popular valuation of mans total productive capability. That this valuation has aform is a fact of
profound implications that should ultimately revolutionize the social sciences.
ENDNOTE: THE MENTATIONAL CONNECTION
It is also possible to link Fibonacci-based robust fractals in biology to a Fibonacci-based unconscious
human mentation that governs impulsive herding behavior. This link completes a tentative
explanation of how the Wave Principle is produced. For an introduction to this subject, please see
the companion report, Science v Is Revealing the Mechanism of the Wave Principle.
NOTES
1. Fractal objects whose properties are not restricted display selfsimilarity, while those that
develop in a direction such as price graphs display selfafjnity. The term self-similar is often
employed more generally to convey both ideas.
2. For more on this topic, see Johansen, A. (1997, December). Discrete scale invariance and
other cooperative phenomena in spatially extended systems with threshold dynamics
(Ph.D. Thesis). Somette, D. (1998). Discrete scale invariance and complex dimensions.
Physics Reports 297, pp. 239-270.
3. Mandelbrot, B. (1988). The fractal geometry of nature. New York: W.H. Freeman.
4. Mandelbrot, B. (1962). Sur certains prix speculatifs: faits empiriques et modele base sur les
processus stables additifs de Paul Levy. Comptes Rendus (Paris): 254, 39683970. And
(1963). The variation of certain speculative prices. oumal of Business: 36,394419.
Reprinted in Cootner 1964: 29 i -337. University of Chicago Press.
5. Mandelbrot, B. (1999, February.) A multifractal walk down Wall Street. Scientific
American, pp. 70-73.
6. Gleick, J. (1985, December 29). Unexpected order in chaos. This World.
7. Sornette, D., Johansen, A., and Bouchaud, J.P. (1996). Stock market crashes, precursors
and replicas. Journal de Physique I France6, No.1, pp. 167-175.
8. Mandelbrot, B. (1999, February.) A multifractal walk down Wall Street. Scientific
American, pp. 70-73.
9. Elliott, R.N. (1938). The waue pinciple. Republished: (1994). RN. Elliotts Masterworks - The
Definitive Collection. Prechter, Jr., Robert Rougelot. (Ed.). Gainesville, GA: New Classics
Library.
10. Elliott, R.N. (1940, October 1). The basis of the wave principle. Republished: (1994). RN.
Elliotts Master-works - The Definitive Collection. Prechter, Jr., Robert Rougelot. (Ed.).
Gainesville, GA New Classics Library.
11. 1 Arneodo, A., Argoul, R. Bacry, E., Muzy, J.F. and Tabbard, M. (1993). Fibonacci
sequences in diffusion-limited aggregation. Growth Patterns in Physical Sciences and
Biology, edited by Juan Manuel Garcia-Ruiz, Enrique Louis, Paul Meakin and Leonard M.
Sander. New York: Plenum Press.
12. Weibel, E.R. (1962). Architecture of the human lung. Science, No. 137 and (1963)
Morphometry of the human lung. Academic Press.
13. West, BJ. and Goldberger, AL. (1987, Jul/Aug). Physiology in fractal dimensions.
American Scientist, Vol. 75.
14. Penrose, R. (1994). Shadows of the mind - a search for the missing science of
consciousness. Oxford University Press.
15. Stanley, H.E., Buldyrev, S.V., Caserta, F., Daccord, G., Eldred, W., Goldberger, A.,
Hausman, R.E., Havlin, S., Larralde, H., Nittmann, J., Peng, CK, Sciortino, F., Simons, M.,
Trunfio, P., and Weiss, G.H. (1993). Fractal landscapes in physics and biology. Growth
patterns in physical sciences and bioloa. Sew York: Plenum Press.
16. Ibid.
17. Arneodo, A., et al. (1993). Fibonacci sequences in diffusionlimited aggregation. Growth
patterns in phyical sciences and biology.
18. Clouds and mountains, which are indefinite fractals, have a Hurst exponent near 0.8.
Neurons (which grow as branching fractals) and the stock market (which grows as waves)
have a Hurst exponent related to phi. These studies prompt me to suggest the hypothesis
that fractal objects that manifest as branches or waves, i.e., the fractal objects of growth
and expansion, will have a Hurst exponent related to phi, setting them apart from other
fractal objects, which will have other Hurst exponents. What this means is that robust fractal
objects split the difference between two Euclidean dimensions by .618, while other fractal
objects do not. In other words, PhCrelated dimensionality is a property only of robust
fractals.
BIOGRAPHY
Robert Prechter first heard of the Wave Principle in the late 1960s while studying psychology at
Yale. In 1976, while at Merrill Lynch in New York, Bob began publishing studies on the Wave
Principle. In 1978, co-authored, with AJ. Frost, Elliott Wave Principle-?@ To Market Behavior, and in
1979, started The Elliott Wave Theorist, a publication devoted to analysis of the U.S. financial
markets. In November 1997, Bob addressed the International Conference on the Unity of the
Sciences (ICUS) in Washington, DC, an international forum on interdiscipiinary scientific issues. The
paper he presented at that conference was later expanded into his most recent book, The Wave
Principle of Human Social Behavior and the New Science of Socionomics, which was published in
1999.

Return to Table of Contents



3: THE INTERACTION OF TRENDINESS MEASURES AND TECHNICAL
INDICATORS
Basil Panas, CFA, CPA, CMT
PART I. INTRODUCTION
Background. Technical analysis has produced a plethora of indicators. Textbooks often classify them
according to computational input: price, time, volume and sentiment. Practitioners need a taxonomy,
which relates indicators to market phases. The art of technical analysis involves matching indicators
with changing market conditions. Prices go through periods of trending and non trending. The
implications of this are profound. Investors and traders must distinguish between trending and
trading markets and adjust their trading tactics accordingly.
Definition of Trendiness. Although they are related, trendiness and volatility are different
phenomena. A trend exists when prices are making higher highs and higher lows (uptrend) or lower
highs and lower lows (downtrend). Trend is thus a function of the directionality of price changes.
Volatility is a function of the size of price changes. Thus a strongly trending market displays both
trendiness and volatility. However, a wide trading range displays little trendiness but much volatility.
Finally, a very tight trading range is an example of low trendiness and low volatility. If market
participants are to rely on different indicators depending on the trendiness of the market, they need
to measure the directionality of price changes.
Hypothesis. This work proposes coordinating trend-following and counter-trend indicators using a
measure of trendiness. The measure would characterize price action as trending or non-trending and
thus select a trend-following or counter-trend indicator. The danger is that multiple indicators dilute
each others effectiveness. The promise is that they become synergistic complements.
Theoretical Model. A simple regime-switching model was used to test the hypothesis. The model
addressed three issues: how to trade in trending markets, how to trade in non-trending markets and
how to distinguish between the two. Success depended on harmonizing the solutions components.
The model employed exponential moving averages (EMA) for trending and Welles Wilders Relative
Strength Index (RSI) (see bibliography) for non-trending markets. The Directional Relative Volatility
Index (DRVI) described by Robert M. Barnes (see bibliography) measured the markets trendiness or
directionality and dictated whether EMA or RSI signals were taken. Testing Methodology. The test
subjects were the 30 stocks listed in the appendix. They consisted of daily prices over various
fiveyear periods. The stocks were divided into three groups according to their characteristic price
action: trending, non-trending and mixed.
The benchmark tests consisted of EMAs and the RSI over lookback periods of 10, 20, 30 and 40
days. The hypothesis tests included these two indicators and the DRVI. The DRVIs look-back period
was 20 days. Its trendiness threshold was 0.5.
The tests were averaged for evaluation purposes. The limited number of parameters avoided the
dangers of overoptimization. The tests assumed starting capital of $10,000 and commissions of $30
per trade which was executed at the next days opening price. All available capital was committed to
each trade.

PART II. BENCHMARK TESTS
Background. Benchmark tests for all thirty stocks were established separately for the EMA and the
RSI. These tests did not include a trendiness measure.
Exponentially Smoothed Moving Average
The trading rules for the EMA were:
Go long when: todays close > EMA. Go short when: todays close < EMA.
Table 1 summarizes the results. It gives the average return from all the EMA tests for each class of
stocks. System close drawdown is the largest equity dip (relative to the initial investment) based on
closed out positions. It is the maximum amount a closed out position fell below the initial investment
amount.


As might be expected, the EMA performed best on trending stocks, worst on non-trending stocks
and somewhere in between on mixed stocks. This was true of both measures of performance.
Relative Strength Index (RSI)
The trading rules for the RSI were as follows:
1. Go long when RSI crosses above 30. Stay long if RSI drops below 30.
2. Go short when RSI crosses below 70. Stay short if RSI drops below 30.
Table 2 summarizes the results. It gives the average return from all the RSI tests for each class of
stocks.

As might be expected, the RSI performed best on non-trending stocks, worst on trending stocks and
somewhere in between on mixed stocks. This was true of both measures of performance.
PART 3. TESTOF HYPOTHESIS Directional Relative Volatility Index
The DRVI scores trendiness from 0.0 to 1.0. The tests assumed a trend (trading range) when
readings equal or exceed (are less than) 0.5. This threshold was used because it is the midpoint of
the range. Empirical testing showed it was effective in separating trending from non-trending periods.
The trading rules for this system were of these:


The combination of an EMA, DRVI and RSI performed best on trending stocks, worst on non-
trending stocks and somewhere in between on mixed stocks. This was true of both measures of
performance.
Analysis of All Test Results
Table 4 compares the two sets of benchmark tests (EMA and RSI) with the tests of the composite
(EMA, DRVI, and RSI).

The data suggest that combining a trendiness measure with technical indicators improves
performance in certain cases. Regardless of the type of price action, trending, non-trending or
mixed, better results were achieved with the composite model than the EMA alone. However, in the
case of the RSI, the composite improved performance only in trending markets.
The implication is clear. A trendiness measure works best to eliminate whipsaw signals. This is
consistent with the fact that whipsaws are usually associated with trend-following indicators (such as
an EMA).
A visual inspection of the charts with their trading signals confirms this. Many bad EMA signals were
eliminated by the DRVI. The DRVI did not, however, eliminate many bad RSI signals. Apparently,
the RSI formula is better able to pinpoint the boundaries of a trading range than the DRVI.
The RSI compares prices to their own recent history while the DRVI compares readings to a
threshold, in this case 0.5. Manipulating the DRVI trendiness threshold does improve results. Tests
show that lowering the threshold in a trending market (to 0.25) makes the EMA more effective. This
generates signals earlier in the trend. Raising the threshold in a trading range (to 0.75) eliminates
more bad EMA signals and permits more accurate RSI signals. The problem is identifying trending
and trading periods ahead of time.
The data do not show any predictive value in the DRVI trendiness readings. In fact, the DRVI signals
changes in trendiness on a slightly lagging basis. This can be adjusted, as described above, by
manipulating the threshold level.
PART IV. TRADING APPLICATIONS
Traders should filter the signals from trend-following indicators with a trendiness measure. They can
enhance the measures effectiveness through its sensitivity setting or threshold. Traders can use
traditional technical tools to identify trending and nontrending periods and adjust the threshold
accordingly. For example, traders would use a high threshold as long as prices remain in a trading
range. After a breakout (in either direction), they would switch to a low threshold. In uncertain
markets they would default to a middle threshold.



BIBLIOGRAPHY
I Achelis, Steven B., Technical Analvsis From A to Z, Chicago, IL: Irwin Professional
Publishing, 1995.
Barnes, Robert M., Trading in Chonnv Markets, Chicago, IL: Irwin Professional Publishing,
1997.
Wilder, J. Welles, New Concerns In Technical Tradincr Svstems, Greensboro, NC: Trend
Research, 1978.
BIOGRAPHY
Basil Panas earned a bachelors degree in Accounting from Rhodes University, South Africa. He is a
CPA and holds the CFA designation. He has seven years of experience managing a fixed income
portfolio ($60 million) for the City of West Covina, California, using both fundamental and technical
tools. He is currently employed by the Metropolitan Transportation Authority in Los Angeles. He may
be reached at 909/931-4926 or bpanas @ ibm.net.

Return to Table of Contents



4:HEAD AND SHOULDERS ACCURACIES AND HOW TO TRADE THEM
Serge Laedermann
INTRODUCTION
The Head-and-Shoulders pattern is probably one of the bestknown and venerable of chart
formations. It is considered as one of the most reliable by all odds according to Edwards and
Magees own words in their reference work.
Martin J. Pring quotes the Head-and-Shoulders as probably the most reliable of all chart patterns,
while John J. Murphys analysis is almost identical when considering probably the best known and
most reliable of all major reversal patterns. Some official legitimacy was gained in August 1995,
when the New York Federal Reserve astonished both economists and technicians in publishing a
computer study on the validity of the case: Head-and-Shoulders: Not just a flaky pattern. The old
formation undoubtedly stands the test of time and represents a powerful tool in todays trading and
analysis. The suggestion is to invite you on a journey inside the Head-and-Shoulders. Some
discoveries are still to be made. Rounding Bottoms and Complex Head-and-Shoulders are Multiple
formations as well, and should be traded on a level of confidence that any technician should gain
before acting. Traders have always been faced with some weakness when trying to profit from the
pattern. It is not being irreverent to state that technical literature does not provide enough clear
statistical accuracies on the subject. Most observations are pertinent orjudicious, but they hardly help
when dealing with a trade to do or to avoid.
This paper will first specify what can be considered as a valid or adequate Head-and-Shoulders.
Harmony limits and rules to follow will be shown according to classical practice. Secondle the study
will analvze known facts about Head-and-Shoulders. Probabilities and numbers will be put forward
on the major topics such as Volume, Measuring Objective, Pullback and Pattern Length, among
others.
In the third nlace. the naner will suggest trading techniaues to profit from the nattern and how to
estimate the obiective. The entry level, the stop and three different ways of measuring the objective
will be discussed. A complete track record will be established, showing the pattern degree of
efftciency and the level of risk to take in order to make a living from it. Precise net valuations will be
displayed.
METHOD
Daily data from January 1990 till October 1997 have been selected on the S&P 500, US Treasury
Bonds, Swiss Franc and Gold in an attempt to cover the major market sectors. Data are on a cash or
spot basis in order to avoid roll-over gaps implied by the future markets positive or negative carry.
The idea is to detect possible divergences between stocks, interest rates, currencies and
commodities. Do Head-and-Shoulders develop the same way on various markets? Are all markets
profitable? Is the Risk-Reward indisputable? These questions need tentative precise answers.
Subjectivity is clearly the main difftculty when dealing with a pattern formation. After the fact
recognitions make trades more attractive than they are in the real world. Furthermore, patterns found
on a chart may vary from one technician to another. Also, the picture may sometimes even prove to
be rather different the following day for oneself!
However, well-trained individuals know very well that there is no room for various methods of
assessment in that field; the margin is in fact pretty narrow. Despite the lack of statistics, many
examples of Head-and-Shoulders are to be found in technical books, therefore diminishing
misinterpretation. This work represents a full coverage of nearly eight years on four major liquid
markets. All patterns discussed have been carefully selected in respect of the classical methodology
as well as strict rules. The information and opinions contained have been compiled in good faith.
The author asserts that ethical standards of professional conduct have been highly respected. He is
available, upon request, to defend any position taken or decision made.
This studv is based on dailv charts and deals solelv with Head-and-Shoulders which are tradable bv
evervbodv, in contrast with patterns which are only caught by floor traders. The natterns selected in
this studv meet two criteria. Thev are followed bv a Close bevond the Neckline, and a Pullback either
to the Breakout level or the Neckline. on a dailv chart. In practice, you will have the time to analyze
many markets and detect which one has just experienced a Breakout of a Head-and-Shoulders.
Your next-day limit order will be easily calculated as well as your exit levels (Stop and Objective).
RECOGNITION
According to Robert D. Edwards and John Magee, the only qualification on an up-sloping Neckline is
that the Bottom of the recesion between the Head and Right Shoulder must form appreciably below
the general level of the top of the Left Shoulder. The logic applies for a down-sloping Neckline as
well. In modern trading, the adverb appreciably tends to disappear as commodities charts look
more stretched than stocks charts in the 1950s.
Multiple or Complex Head-and-Shoulders consisting of some Left and Right Shoulders, or even
Tvvo-Headed, are common. However, the Neckline is not always easy to draw as two or even
several possibilities often exist. Traders should take a position on any Pullback following an obvious
Breakout, even in the case of multiple formations.


Head-and-Shoulders Tops or Bottoms are to be found at the end of a trend. It is not expected to
consider as a true Head-and-Shoulders a pattern whose size is more than half the amplitude of the
prior trend. John J. Murphy states that Reversal patterns can only be expected to reverse or retrace
what has gone before them. In other words, the maximum objective is the size of the prior move.
Therefore, too-big patterns may not reach their measuring objective, and imply a doubtful Risk-
Reward ratio. Traders may avoid such trades which usually oblige them to place a Stop too far for
fear of premature exit.
Symmetry is the key word for a Head-and-Shoulders pattern, even more so in a group of related
formations which carry the same technical implications. Rounding Tops and Bottoms are Multiple
formations as well and should be traded on a Pullback as soon as an obvious Breakout is detected.

The pattern has to be in Harmony with the environment. The word is somewhat romantic, but
describes the kind of level of confidence any trader should gain before acting. Some technicians may
consider this Gold-Comex development as a valid Head-and-Shoulders Top, but the assumed Right
Shoulder represents, in fact, the move which negated the formation. The objective completion, a few
days later, does not alter the picture.
Some situations are surprisingly not tradable. The Swiss Franc IMM picture looked promising in May
1997. Why was this trade not possible? This is a good example of an After the fact trade. Whenever
the first Breakout occurred, the Symmetry or Harmony of the Pattern was rather poor. The
downward-sloping Neckline was steep, but not eliminatory. However, the Head and Left Shoulder
distance as compared to the Head and Right Shoulder distance was a matter of worry. The lack of
Harmony did not encourage the desire to trade when the Pullback eventually occurred.
Later on, the pattern looked more balanced and the decision to trade was logically taken. This time,
the market did not give another chance to get in. We must learn to live with it.

FREQUENCY
One hundred and twenty one Head-and-Shoulders patterns have been found using daily charts on
the S&P 500, Swiss Franc, US TBonds and Gold from January 1990 till October 1997 (94 months).
Sixty percent of all formations were Head-and-Shoulders Bottoms, Gold recording an anomalous
76% of Bottoming patterns. Excluding Gold, Bottoming formations accounted for 53% of all patterns.


PULLBACK
Sixty five of the 121 Head-and-Shoulders found experienced a Pullback powerful enough to initiate a
trade. The entry or limit order has been placed at the Breakout point or the Neckline level, whichever
was the less ambitious. Whenever a Breakaway Gap occurred, the limit was placed at the less
ambitious side of it (market should try to fill the Gap but may not succeed in true Breakaway
situations).
Pullbacks have been seen 59% of the time in the case of Top formations, but 69% of the time in
Bottoming ones. This is a prob able confirmation of the gravity factor, showing that a market
advance takes usually more time to develop than a market decline. Eighty percent of S&P 500 and
US T-Bonds Bottom patterns experienced a Pullback after the Breakout. This analysis is not
signi!ticant for currencies (either bullish or bearish, depending on the country). Gold had too few Top
patterns to rely on the Pullback ratio observed in Top cases.



PULLBACK LIMIT ORDER



OBJECTIVE
The classical method to determine the minimum Objective is based on the height of the pattern. The
vertical distance from the Head to the Neckline is projected from the point where the Neckline is
broken (purists use a logarithmic scale).
Our sample of 79 Head-and-Shoulders demonstrates that another method should be considered
when trading patterns which are experiencing a Pullback (in other words, patterns which are
tradable).
The minimum Objective should be estimated by measuring the vertical distance from the Bottom of
the hollow between the Head and the Right Shoulder, up to the trendline joining up the Heads crest
and the Bight Shoulders crest.

That distance is then projected as in the classical style. An even more conservative method has
been tested, using the vertical distance from the Right Shoulders crest to the heckline, then
projected as in the classical style.
Cumulative total profits, on all trades, for the third method is 71.9%, clearly behind the classical
measurement (77.8%) and the recommended one (79%)

Nearly 60% of minimum objectives have been reached using the recommended style, outperforming
clearly the classical one (only 46% of objectives met). The conservative method managed to record
an impressive, but misleading, 70% of success. This is where the Profit & Loss per trade comes into
play, or the other side of the picture.

The performance per trade is unsurprisingly favorable to the classical method, almost compensating
for the poor rate of success. However, method two is the best combination taking into account all the
parameters.

The Quality difference between method one and two is not so clear in terms of cumulative
performances, but the picture is much better if we analyze the length of each transaction. On
average, a trade (from the entry to the exit day) lasts 8 trading days with the recommended method,
while it takes more than 10 days for the classical one. Considering that 2/3 of the trades in method 1
and 2 are identical, we have to understand what happens with l/3 of them. Analysis shows that the
classical measuring objective is often too ambitious and is therefore missed. Then, the short-term
trend reverses, and either the Stop limit is activated or the position sold at the Objective when the
initial trend resumes, much later on. A position lasts 6 trading days with the conservative method.
The potential move is, however, chronically underestimated.
Objective Not Tradable
Thirty live percent of patterns did not experience a sufficient Pullback and have been considered as
not tradable. In almost 100% of the cases, the market reached the target quickly, sometimes the
same day as the Breakout occurred. Two thirds of the not tradable patterns lasted less than 10
days. It is highly prob able that Pullbacks occurred on intra- day charts for the majority of these
formations.
VOLUME
Volume characteristics are considered of critical importance in assessing the validity of the pattern.
Activity is normally high during the formation of the Left Shoulder and tends to be quite significant,
but lighter, when the price is at the peak. Right Shoulder is usually accompanied by lower Volume, a
typical warning of diminishing buying activity during a Head-and-Shoulders Top, or the end of the
selling pressure in the case of a Head-and-Shoulders Bottom.
Confirmation is provided in ranking the Volume: 55% of Left Shoulders recorded the highest Volume
as compared to 32% for Heads and 13% for Right Shoulders. Objectives reached or not, the
numbers barely change. Future patterns failures are therefore not to be found using that statistic
alone.

The lowest Volume was recorded on 61% of Right Shoulders, 30% of Heads and 9% of Left
Shoulders. Numbers were almost identical for Objectives completed and Objectives missed, which is
again not helpful in detecting which Head-and-Shoulder is going to fail.

Thirty eight percent of the mid (or Nr 2) Volume has been recorded on Heads, 32% on Left
Shoulders and 30% on Right Shoulders. Thirty four percent of patterns represented the ideal Volume
sequence: Left Shoulder and the highest Volume, Head and the mid Volume, Right Shoulder and the
lowest Volume. A small 4% developed in the most unusual way, with an inversed Volume sequence.
Volume at Bottom
Theory indicates that the most important difference between Head-and-Shoulders Tops and Bottoms
is the Volume. At Bottoms, the market requires a significant increase in Buying pressure, reflected in
higher Volume on up moves. The rally from the Head should show an increase of activity, often
exceeding the Volume generated during the up move following the Left Shoulder.
Thirteen percent of Right Shoulders recorded the highest Volume, 5% at Tops and 8% at Bottoms. In
this particular situation, 75% of Head-and-Shoulders Tops missed the recommended Ob jective,
while 80% of Bottom patterns succeeded. This is an indication that a high Right Shoulder Volume is
not comforting at Tops, but not really detrimental at Bottoms.
The Left Shoulder recorded the lowest Volume in 9% of all cases, 1% in Top and 8% in Bottom
formations. Objectives have been met in slightly more than 50% of the formations.
Volume Amplitude
The specific Volume number is not of major importance to the Technician. However, it is often
necessary to classify the Volume into one of three categories: High, Low, Average. Giving a mark to
each category (1 point for High, 2 points for Average and 3 points for Low), the sample shows an
extreme similarity to the grading study described before.

Forty one percent of patterns recorded the highest Volume (as compared to the Head and the Right
Shoulder) and also a high Volume in amplitude, the typical case.
Despite this ideal situation, the recommended objective has been met in only 63% of the cases, not
a significant hedge over non typical situations.
Twenty five percent of patterns recorded the lowest Volume on the Right Shoulder and a low Volume
amplitude as well. This scenario produced an impressive 80% of accomplished Objectives, a
remarkable performance.
DURATION
Measuring Objectives is discussed in terms of height, but too few studies deal with classical
Objectives durations. In our sample, Head-and-Shoulders lasted 30 trading days, on average, from
the start of the pattern until completion. A pattern started whenever the move which was at the very
beginning of the Left Shoulder, crossed the future Neckline. The end of the pattern was materialized
by the Breakout. Trades, initiated on the Pullback day, lasted 8 days, or 27% of the patterns
duration, on average. This is a good indication of the time required when trading a Head-and-
Shoulders. The durations of trades were identical for both reached and missed recommended
Objectives, which means that the Stop order method was efficient (see Trading).

One third of trades lasted less than 20% of patterns durations (for example, less than 6 days on a
30 days pattern). One half were shorter than 30% and two-thirds less than 40%.
However, the most significant observation lies in the 50% or less category where 86% of trades
lasted, at the maximum, half the durations of the patterns. This is a nice probability to put forward
whenever a measuring Objective is activated.
Bottoms are generally flatter and generally take more time to develop, as the market falls to the floor
more quickly due to the gravity effect. It does require a much greater effort for the market to launch a
new Bull trend.
This characteristic is clearly confirmed by the current study. Top patterns lasted 23 days on average,
while Bottom ones had durations of 34 days, a 50% differential.
Trades were completed after 8.3 days for Bottom formations, slightly above Top ones (7.6 days),
showing that velocity was quite similar after the Breakout. Accordingly, Bottom trades tended to be
shorter (as a percentage of patterns durations).
However, the major outcome was that 86% of trades lasted, at the most, half the size of all the
patterns found for both Head-and-Shoulders Tops and Bottoms. Symmetry is perfect knowing that
44% of trades lasted, at the most, onequarter of the duration of all patterns for both Top and Bottom
formations.
Lateral and vertical movements are proportional to each other as suggested by some theories, a
statement of the obvious.
BREAKOUT
A Head-and-Shoulders is not complete until the Neckline is decisively broken on a closing basis: The
Breakout Day. A close beyond the Neckline not only completes the pattern, but also activates the
minimum measuring Objective. A sharp increase in Volume is usual during the Break out, a factor
not always dominant in a Head-and-Shoulders Top. Following a Breakout, the market runs and
quickly peaks. In 85% of cases, the Breakouts peak was reached the day of the Breakout (Day 1) or
the following day (Day 2).

The average Breakouts peak, or incursion level, reached three-eighths of the expected measured
move. In other words, three-eighths of the Objectives were accomplished before the Pullbacks.

BREAKWAY GAP
Start of 24h trading as well as a high liquidity explained the absence of Gaps (only 5%)) still
numerous on stocks charts.
RISK VS REWARD
The average gross profit at the recommended Objective was 1.497 higher than the potential loss at
the Stop (Exit) level.
TREND
Head-and-Shoulders are reversal patterns. Thus, 78% of trades were initiated against the Mid term
Secondary trend.
TRADING
As mentioned before, this study deals solely with Head-and-Shoulders which are tradable by
everybody. One hundred and twenty one Head-and-Shoulders patterns have been detected using
daily charts from 1990 until 1997. Pullbacks occurred 79 times, allowing in practice anyone to enter
all 79 trades (see Frequency, Pullback & Method). The trades are first analyzed on a very
straightforward basis showing yearly gross gains and losses on each market.

Eighty nine percent of traded Pullbacks reached both the Neckline and the Breakout level. However,
a limit placed at the most ambitious level (see Pullback) would have proved to be costly despite an
estimated 10% entry level savings. The total profit would have been cut by as much as 20%. Sixty
three percent of trades generated a profit. The average profit per trade was 2.29%, much higher than
the average loss of 0.90%. No loss above 2.50% had been recorded and a small 3% of trades lost
more than 2%. Half of the winning trades exceeded 2% gain and 1 out of 10 exceeded 3% gain.
SYSTEM



In order to value the net return of our 79 trades in the real world, the following rules have been
established: $100,000 was the initial cash put in the account. A contract position in any market never
exceeded 2.5 times the accounts value, a reasonable leverage which boosted the performance.
Margins never rose above 15% of the net equity and could have been multiplied by 3, with positions
in all 4 markets, without causing any disturbance for the trading. Round turn Commission and
Slippage were $80 per contract.
At an average pace of 10 trades per year and knowing that each trade lasted 8 days on average, the
interesting feature was the consistent high level of cash in the account.



Therefore, nothing could be more justified than trading other technical patterns like Double Tops &
Bottoms or Triangles using the same account equity and the same system. Short term traders may
use 10 days of intraday tick by tick charts and trade roughly 100 times per year.
REFERENCES
Edwards, Robert D. and Magee, John; Technical Analvsis of Stock Trends 6th Edition,
1992 -,
Pring, Martin J.; Technical Analvsis Explained, 3rd Edition, 1991
Murphy, John J.; Technical Analvsis of the Futures Markets, 1986
I Murphy, John J.; Intermarket Technical Analvsis, 1991
Shaleen, Kenneth H.; Volume and Open Interest, 1991
Shaleen, Kenneth H.; Technical Analvsis & Ootions Strategies, 1992
Chang, Kevin P.H. and Osler, Carol; Federal Reserve of New York. August 1995 Reoort,
Head & Shoulders: Not Just a Flaky Pattern
Etzkorn, Mark; Futures Magazine, January 1996 article, Fed& Shoulders
BIOGRAPHY
Since 1998, Serge Laedermann has been a partner at GF Geneva Finance, Geneva, Switzerland,
focusing on Private Banking. Fundamental analysis, as well as technical analysis, is used in making
investment decisions. Technical analysis is his major tool and he is mainly a specialist in pattern
recognition.
In the 1980s Mr. Laedermann was a floor trader and a technical analyst at Credit Suisse and, later
on, Chief Economist and Analyst at Bank of New York - IMB, Geneva.
In 1987 Serge cofounded the Swiss Association of Market Technicians (SAMT) and is currently a
member of IFTA. (see over)






Return to Table of Contents



5: VOLATILITY AND STRUCTURE: BUILDING BLOCKS OF CLASSICAL CHART
PATTERN ANALYSIS
Daniel L. Chesler, CTA, CMT
INTRODUCTION
Like many technicians, I began my study of technical analysis with classical bar chart patterns: trusty
head-and-shoulders, triangles, wedges and so on. Though I still rely on chart patterns today, not all
technicians share my respect for this fm of analysis. Some technicians criticize classical chart
patterns as being dqendent on the imagination of the chartist rather than on objective rules. While
perhaps the essence of charting is subjective interpretation, I what Ifind even more interesting is
the widespread and unapologetic use of classical chart patterns among successful analyts and
traders2 In fact, the question of whether chartists assume a reality that does not exist seems almost
moot given classical chartings longevity over the past century.
Yet the question remains why classical charting, a technique that up pears to involve more
exceptions than rules, attracts such a loyal following among otherwise skeptical professionals. What
do these analysts and traders actually see when they identify a classical chart pattern? The answer
I be&e does not lie hidden in the minutiae of traditional chart pattern definitions. More likely the
answer is found in a set of general conditions that ex@-ienced chartists recognize intuitively.
Traditional chart pattern definitions stress the uniqueness of individual chart pattern shapes. For
instance, think of the many variations on, the triangle theme alone: symmetrical, ascending
descending, wedge type, inverted, inverted with rising or descending hypotenuse, continuation,
reversal, top, bottom, et al., each with its own time, pice, and volume subtltties. It is my belief that in
ascribing this much significance to individual patterns, we also understate the common thread that
binds all chart pat terns.
In the following discussion I will try to &scribe that common thread by breaking chart patterns into
generic components and examining each in turn before assembling them into a single model. My
goal is to suggest a more compact and user-friendly a@roach to classical chart pattern analysis by
focussing on the common elements that appear to characterize classical chart patterns in general.
APPROACH
First, I will review the history of price charts along with the background and basic tenets of classical
chart pattern analysis. While these may be tired subjects for many readers, they are worth revisiting
as they reflect the conventional views that we seek to expand. I will also discuss the role that
classical chart patterns play within the broader scope of market analysis. Some of the practical
strengths and weaknesses of classical charting will also be covered.
Next, a simple conceptual model will be presented, which attempts to depict classical chart patterns
in terms of two basic components: the volatility component and the structure component. Individually
these observations will not constitute new or unique theory on the subject of bar chart patterns or
price behavior. Taken together, however, they should help reduce the degree of separation between
what is typically perceived as a diverse range of classical chart pattern definitions. Using recent
examples from the US stock market, I will show how the model can be used to simplify pattern
recognition and enhance the timing of chart pattern-based trading decisions.
Again, my goal is not to advance a particular view of chart pattern analysis into the realm of verifiable
science. Rather, I hope to add a measure of order to what some technicians view as the ambiguous
process of finding and trading classical chart patterns.
PRICE CHART PRIMER
The earliest use of price charts has been traced back to 17th century Japan where it is believed
price charts were first used to record and analyze the movements of the Japanese rice market. The
use of price charts in the United States, however, did not develop until the late 19th century. Prior to
the widespread use of charts in the U.S., price and volume analysis was generally limited to what
one could observe and memorize as live quotes ran across a mechanical ticker tape. This practice
became known generally as tape reading.
In the late lBOOs, the number of active stocks was few. However, as this number increased,
following the list of active stocks on the tape became more difficult. Summarization of the data into
price charts was the inevitable result.
Thus, a price chart is merely a graphic record of price and volume activity over a length of time -a
graphic ticker tape so to speak. In this context one can understand how price and volume
relationships gleaned from the practice of tape reading ultimately shaped charting principles. As one
technician aptly put it, tape reading was just primordial technical analysis.
The earliest charts used in Western technical analysis are believed to be point-and-figure charts and
existed at least fifteen years before the advent of bar charts5 Point-and-figure charts differ sub
stantially from bar charts in that they do not specifically record time and volume data. They are noted
for their ability to highlight consolidation zones, which generally imply either accumulation or
distribution activity. The subject of this paper, however, relates only to bar charts and bar chart
patterns.
Bar charts, probably due to their ease of construction, have been the most popular form of price
charts since their introduction in the late /ewebBOOS./eweb Each bar consists of a vertical line
representing the range of prices traded over a defined period: an hour, a day, a week, a month, etc.
Prices are plotted on the vertical axis and time on the horizontal. Bar charts often include a graph
along the bottom of the chart depicting volume activity and in the futures markets the open interest.
The vertical axis of a bar chart is generally plotted on either an arithmetic or logarithmic scale, with
the arithmetic scale being the more popular form. A logarithmic scale shows equal percentage
increments of price rather than equal absolute increments as with an arithmetic scale.
CLASSICAL CHART PATTERN EVOLUTION
The 1948 book Technical Analysis of Stock Trends, written by Robert D. Edwards and John Magee,
is often referred to as the bible of technical analysis. It is considered by many to be the definitive
reference source for information on classical chart patterns. However, Edwards and Magee
attributed the credit for their ideas to the original research and theories of both Charles Henry Dow
and Richard W. Schabacker.
Dow was a co-founder of the Dow-Jones & Co. financial news service and the first editor of The Wall
StreetJournal. He created the original Dow Jones stock averages in the late 1800s and wrote a
series of editorials in the Journal that analyzed the price movements of these averages. After his
death in 1902, William Hamilton and Robert Rhea refined Dows ideas into what became known as
Dow Theory.
Loosely defined Dow Theory is a method of analysis that utilizes specific price patterns to infer the
direction of the markets primary trend. If prices are making a succession of new highs, interrupted
by shorter-term reactions which terminate above previous reaction lows, the trend is considered to
be up. Conversely, a succession of new lows in price accompanied by lower highs on intervening
rallies indicates a downtrend. Dow recognized that on all levels, from major swings down to day-
today fluctuations, prices do not move in a straight line along their trend but rather in a pattern of
zigzags or waves. This observation by Dow is significant to chart pattern analysis as it forms the
basis of all classical chart patterns; combinations of zigzag or wave patterns make up the core of
all classical chart pattern definitions. Other Dow Theory principles also underlie classical chart
pattern analysis. These include Dow Theory lines which appear as a narrow range of price
fluctuations, and indicate a period of stagnation in price where buying and selling forces are roughly
equal. As Edwards and Magee noted, a degree of coincidence appears to exist between Dow
Theory lines and what might otherwise be viewed as classical chart formations. Finally, the idea that
volume tends to expand on price movements in the direction of the dominant trend is also a tenet of
both Dow Theory and classical chart pattern analysis.
While Dow focused on the longer-term trends of business activity as reflected in the relationship
between the closing prices of his averages, it was Schabacker who adapted these principles to bar
charts ofindividual securities on a short to intermediate time frame. In 1930, while employed as the
financial editor of Forbes magazine, Schabacker authored Stock Market Theo-yy and Practice, a
reference work on the subject of the stock market and trading. He also pub lished a manual in 1932,
Technical Analysis and Stock Market Profits, which expanded upon the principles introduced in his
first book. It was primarily through these two texts that Schabacker pointed out the various bar chart
patterns that were later discussed and popularized by Edwards and Magee. Thus Schabacker was
the chief architect of the classical chart patterns we know today such as triangles, head-and-
shoulders, et al. To reiterate, these patterns belong primarily to the area of technical theory related to
the trading of individual securities.
There have been other significant contributors to the body of charting knowledge, notably Richard D.
Wyckoff and Ralph Nelson Elliott. Though it would be inaccurate to label the work of either Wyckoff
or Elliott as classical charting per se, some overlap does exist. For instance, like Charles Dow, both
Wyckoff and Elliott sought to identify repeatable price patterns of a cyclical or rhythmic nature.8
Wyckoff and Elliott also viewed the relationship between price and volume similarly to Dow.
More recently formal research has been made into the area of classical chart patterns. While no
definite conclusions regarding the efficacy of classical chart patterns have been reached, there have
been some encouraging results. For example, a 1995 study by the NewYork Reserve Bank found
that the head-and-shoulders chart pattern yielded significant excess profits in select currency
markets Research by Alex Saitta, a technician at Salomon, has shown profitable trading results
using standardized classical chart patterns in the Treasury Bond market.
CLASSICAL CHART PATTERN BASICS
Most charting methods, including classical charting, make use of implied psychological or behavioral
motivations. For instance, doubt is the emotion usually associated with the early stages of a new
trend. After a trend has matured, greed! or fear are thought to be the forces that compel traders to
chase prices up or down even farther, culminating in a frenzied climax of buying or selling activity.
l1 Elliott wave structures are believed to directly reflect a rhythm in nature that manifests itself in
crowd behavior, and ultimately in the shape of market prices.* Classical chart patterns, such as
head-and-shoulders, triangles and others, are thought to be indicative of pool operators or inside
interests who intentionally manipulate the market in distinct phases referred to as accumulation,
markup, distribution, and markdown.
Regardless of the underlying causes attributed to their formation, classical chart patterns rely chiefly
on the interpretation of trendlines, geometric formations and price and volume relationships. The
primary chart patterns that Schabacker pointed out in his first book, Stock Market Theory and
Practice, included patterns of accumulation or bottoming, and patterns of distribution or topping.
Collectively these patterns are known as reversal patterns as they tend to coincide with a reversal
of the prior established trend. Schabacker also identified a second group of patterns as
intermediate or continuation patterns that are found inserted in the progress of an already
originated move.14 As their name implies these patterns suggest only a pause in activity followed
by a continuation of the preceeding trend.
The fact that a chart pattern appears as either a reversal or a continuation pattern does not rule out
plentiful exceptions. For instance, an orthodox head-and-shoulders reversal pattern may develop
into a continuation pattern, or vice versa. Most of the literature on classical chart patterns concedes
this flaw. What can be said with moderate certainty however is that when prices have been in a trend
and suddenly stop advancing or stop declining, they are now doing something else.i5 That
something else is almost always the start of a classical chart pattern of one form or another.
Over time and depending on which analyst or trader you consult, individual patterns within each
category have gone through minor name changes and other slight revisions. For example,
Schabacker originally identified wedges as a reversal pattern, while other technicians have
accepted the wedge pattern as both a continuation and a reversal pattern. However the names and
categoies of the basic area patterns, which exclude all one and two-bar formations such as island
and gap patterns, as well as spike or V reversals, can be broadly summarized as follows:

Patterns such as complex head-and-shoulders, irregular tops and bottoms, simple or naked
trendlines, horizontal support and resistance lines, trend channels and others are also very much
part of chart pattern vernacular. For sake of brevity, however, the patterns listed above safely
represent the majority of all classical chart patterns.
In addition to identifying specific pattern shapes, classical chart pattern analysis also incorporates
an analysis of the relationship between price and volume. For example, a price breakout is
believed to confirm a patterns validity if it is accompanied by increasing volume. In the case of top
reversal formations, this requirement is sometimes relaxed. However, in general, most chart patterns
tend to follow a sequence of high and/or irregular volume in the early to middle stages, with markedly
declining volume in the late stages, just prior to prices breaking out beyond the boundaries of the
pattern. There is as Schabacker explained, . . .the tendency for volume to decline during the period
of formation of a technical area pattern. This shrinkage in activity is especially conspicuous as the
formation nears completion, just before a breakout occurs.i6 Charts IA-1C demonstrate actual
examples of this behavior.
Another feature of classical chart patterns is the implied price target. Following the confirmation of a
pattern, which is normally signified by a price breakout, chartists believe that targets can be
determined that indicate how far prices will either rise or decline. The standard procedure for
determining a price target is to measure the horizontal width of the pattern, in points or dollars, and
then add or subtract this value above or below the point at which prices decisively exit the pattern.
Between the generous ridicule hurled at charting by well known market commentatorsn and the often
exaggerated claims made by overzealous char&, it is probably safe to assume that classical chart
patterns are a misunderstood subject. I have even known experienced technicians who mistakenly
view classical chart patterns as a kind of esoteric knowledge for divining the future direction of stock
prices. In the following section I will utilize quotes from various sources to help clarify the role of
classical chart patterns.
It must be understood that chart patterns were conceived primarily as a timing or trading
technique used for individual trade selection. Though Schabacker did find chart patterns useful as
indicators of the general market, he did not view them as a longterm investment or market
forecasting strategy; for this he considered fundamentals the more important of the two approaches:
Our study has been devoted chiefly to consideration of the technical factors affecting stock market
fluctuations. We have previously seen that such factors work much more swiftly and profitably than
do the fundamentals. The technical side of the market is of special importance for the short-swing
stock market trader - he who tries to take his quick profit and run, and then renew his operation in
some other issue where technical considerations suggest another movement is about to
materialize.*

The technical approach to the market. ..is based upon factors which relate chiefly, or at least more
directly, to the market itself, to the price movement which results from the constant interplay between
those who want to buy...and those who want to sell.. .
In other words, the fundamental factors suggest what ought to happen in the market, while the
technical factors suggest what is actually happening in the market. It is, therefore, the more
important of the two angles for the trader.. .
Thus Schabacker emphasizes the point that technical factors are particularly well suited to serving
the needs of traders, or those who operate on shorter time frames. For Schabacker this specifically
meant the use of bar chart patterns as a means of highlighting accumulation and distribution activity
in individual stocks for the purpose of providing buy and sell signals.
The notion of chart patterns as a tool of the timer is as accepted among knowledgeable observers
today as it was by Schabacker seventy years ago. For example, &-hard Aschinger, Professor of
Economics at the University of Fribourg, Switzerland, makes an indirect but a propos reference to
the nature of charting in a 1988 Swiss Bank Corporation article as follows:
Speculators, . . are defined as basing their investment policy on the behavior of the market itself,
using recent patterns to predict future trends. . . . In reality, many chartists would fall into this
category. . . . The point is that fundamentalists usually follow a longer-range investment strategy,
whereas speculators have a basically short-term orientation.
Aschinger implies that speculators are more concerned with matters of timing than with long-range
strategy. He also links the use of recent patterns with the objectives of speculators as an
accomplished fact. These views echo Schabackers and support the idea that chart patterns
represent a technique belonging chiefly to traders.
Peter Brandt, one of Commodity Corp.s most successful traders for many years, and a speaker at
the 14th Annual MTA Seminar in Naples, Florida, claims to rely almost entirely on classical chart
patterns for making trading decisions. Brandt explains his views on classical charting in a 1990 book
interview as follows:
Classical charting is . . . useful only to highlight a certain defined trading opportunity. It is vital to
keep in mind that over 50 percent of chart formations fail to deliver profitable trades. This may be an
indictment of classical charting as a forecasting tool, but not as a trading tool. Classical charting
principles do not explain all the markets all the time . . . . I am just looking for market situations that
meet certain guidelines

Thus, Brandt discounts any directional inferences of classical chart patterns. He views classical chart
patterns as useful for the purpose of identifying and organizing individual trading decisions rather
than for the purpose of outright prediction. For Brandt, chart patterns serve as a sort of bookmark
that enables trades to be made with reference to a particular set of price levels, risks and potential
outcomes.
The notion that classical chart patterns do not serve as a means of prediction is not necessarily a
new idea.23 In the following quote attributed to legendary trader Jesse Livermore, Livermore
appears to counsel that it is best not to place directional significance in chart patterns:
In a narrow market, when prices are not getting anywhere to speak of but move within a narrow
range, there is no sense in trying to anticipate what the next big movement is going to be-up or
down. The thing to do is to watch the market, read the tape to determine the limits of the get
nowhere prices, and make up your mind that you will not take an interest until the price breaks
through the limit in either direction.
One can assume that the limits of the get-nowhere prices which Livermore speaks of correspond to
the boundaries of a classical chart pattern of some type. More importantly, Livermore reserves
judgement regarding the future direction of prices until the price breaks through the limit. Thus,
Livermore suggests that the forecasting value of chart patterns is subordinate to their main role of
cordoning off the conditions that precede certain trends.
If we accept the idea that classical chart patterns are at best mediocre forecasting tools, then it
follows that the successful use of chart patterns is dependant on the occurrence of a sufficient
number of sustained trends to offset an even greater number of false signals. In this context,
classical chart patterns are by necessity allied with the technical trend-following philosophy, which
states that once a trend begins it is likely to continue.
In sum, two main points emerge regarding the role of chart patterns. The first point is that chart
patterns are intended chiefly as an aid to trading and speculation of individual securities, although
other uses such as general market analysis are also possible. The other is that chart patterns are not
particularly useful as a means of predicting the future direction of prices; waiting for a decisive
breakout in order to confirm the validity of a chart pattern would be unnecessary otherwise.
STRENGTHS AND WEAKNESSES OF CHART PATTERNS
Perhaps the greatest strength of classical chart patterns is their ability to help us participate in price
trends. As trader and analyst William Gann noted, . ..the big profits are made in the runs between
accumulation and distribution.2 Classical chart patterns offer traders a viable means of capturing
these runsn by highlighting the behavior which normally precedes significant trends.
In addition to highlighting specific trading opportunities, chart patterns can also be used to control
risk by forewarning us of trend reversals. It is believed among most technicians that price trends do
not reverse immediately, but rather go through a period of gestation before reversing. These periods
often coincide with the development of a classical chart pattern. Those who wish to control their
open position risk may find chart patterns useful in these situations.
Another strength of classical chart patterns is that they delineate when and at what price to buy and
sell through the use of trendlines and price target objectives. Once the boundaries of a potential
formation have been decided upon and marked off, these boundaries correspond to specific price
and time coordinates that can be used to form specific trading and risk control strategy.
On the weakness side of the balance sheet, chart patterns are notoriously subjective entities.
Surpluses of chart pattern examples exist in books and manuals with no corresponding supply of
fixed pattern definitions. Thus there exists no simple way of determining whether or not an actual
classical chart pattern has been discovered.
Because all classical chart pattern definitions are essentially approximations, chart pattern analysis
contains the potential for abuse by portraying the personal biases of the chartist rather than actual
market indications. The implied directional significance attached to specific chart pattern names,
such as Bearish Wedge or Bullish Triangle, may also interfere with the chartists objectivity. To
the extent that certain chart pattern shapes are associated with specific directional outcomes, the
risk of taking on a preconceived directional bias by the analyst or trader seems inevitable.
Correctly identifying classical chart patterns in time to act on the breakout is also problematic. To
borrow from Dow Theory parlance, how can one tell in what section of the line they are in until it is all
over, and thus perhaps too late to take a position? Conversely, if we act too soon and pre-empt a
chart pattern breakout, the result may be a series of false starts, also known as whipsaws.
THE MODEL
As mentioned earlier, the conceptual model separates chart pattern behavior into two components:
the volatility component and the structure component. Both are equally significant and their order is
presented arbitrarily. Below I have summarized the primary aims of the model:
To offset the lack of classical chart pattern specificity by providing a less subjective though
still not entirely fixed criterion for identifying patterns.
To serve as a notional benchmark for distinguishing valid chart pattern behavior from other
types of market behavior.
To minimize the risk of implied directional biases by excluding the use of traditional bull,
bear or pattern shape nomenclature.
To enhance the timing of trading decisions by more narrowly defining the specific behavior
that coincides with chart pattern breakouts.
THE VOLATILITY COMPONENT
In lay terms, volatility is a measurement that tells us to what extent prices are changing over time. A
market moving up or down 15 or 20 points a day is more volatile than the same market moving up
or down in 3 or 5 point increments. Volatility can also serve as a proxy ofunderlying market activity.
Using the same three stock examples from earlier, Charts 2A-2C demonstrate how changes in
volatility, as measured by the one period range (highest high minus lowest low over the course of
one day), correspond positively with changes in volume over the same time period. This
phenomenon is not unique to daily stock charts; it can be observed across virtually all markets and
time frames.
While the relationship between changes in volatility and changes in volume is by no means an
absolute one, it is robust enough tc help us understand the dynamics behind chart pattern develop
ment and the volatility component of the model. For example, i we assume that for every transaction
there is both a buyer and : seller, volume can be viewed as a measure of the gross supply am
demand at any point in time for a given market. In the case of ou model, volatility has been
substituted for volume as a means of gauging these changes in supply and demand.

We can thus begin to describe the development of a classica chart pattern in terms of volatility as
follows: In the final stages o a price trend, and at the beginning of a so-called classical char pattern,
the market is characterized by relatively high volatility am wide price swings. Next, a gradual process
of declining volatilit begins, leading at last to an area of suspense that marks the begin ning of the
end of the chart patterns development. This fina stage immediately prior to a breakout is marked by
a relative absence of price volatility versus the earlier stages of the chart pattern development. The
market has reached a relative standstill and i positioned at the tripwire of an imminent breakout.
Chart 3 depicts a schematic of the idealized volatility component.
Various tools can be used to help us measure changes in volatil ity that might not otherwise be
obvious through visual inspectior of the chart pattern alone. The standard deviations of closing prices
or an average of daily high-low ranges are two approaches. How ever, I prefer to use Welles
Wilders Average Directional Index (ADX) which is based on an average of excesses between period
to-period ranges, and is smoother in comparison to raw measure, of volatility such as standard
deviation. Although ADX is normall; thought of as a measure of trend strength, this does not
preclude the use of ADX for our purposes. 26 Later I will show how to utilize the ADX indicator (14
period) to gauge the changes in relative volatility that occur during chart pattern development.
THE STRUCTURE COMPONENT
The structure component of the model is not intended as a blue print that tells us where we are
within the structure and hence when we are likely to go next, such as with Elliott wave or seasonal
trad ing patterns. Rather, the structure component represents an ide alized form of cyclic behavior
unique to classical chart patterns ir general. It is an attempt at making that which is important abou
classical chart pattern shapes interesting - and not vice versa.
Specifically, the structure component emphasizes the tendency of chart patterns to exhibit a series
of well-defined and periodic time cycles. This can be observed in most chart patterns as a series of
distinct turning points marked by prominent highs or lows occurring at regular - or very nearly regular
- time intervals. One possible rational for this phenomenon is that cycle periodicity is susceptible to
greater distortion from the effects of trends. Hence, cycle periodicity is noticeably more discernible in
non-trending environments as represented by so-called classical chart patterns.

In contrast, traditional chart pattern definitions focus primarily on the variation in cycle amplitude - or
the height aspect of market time cycles as measured in dollars or points - as a means of classifying
and distinguishing individual chart patterns. Traditional definitions rely on the repeatability of specific
chart pattern shapes as formed by the combination of various cycle amplitudes. The model
however is based on the assumption that generic conditions, such as declining volatility and distinct
periodicity, underlie most chart patterns regardless of their shape or their individual classical
definition.
The structure component also incorporates the tendency of classical chart patterns to exhibit
noticeably overlapping cycles or waves. Most chart patterns reveal this tendency by taking on a
horizontal orientation along the length of the pattern. This aspect of structure highlights one of the
most fundamental differences between price trends and chart patterns: During price trends cycles
overlap minimally, and in the case of very strong trends cycles may not overlap at all. Chart 4 depicts
the idealized structure compo nent of the model.
SCREENING EXAMPLES
In this section I will present several examples of how the model components combine to facilitate
chart pattern based trading decisions.
Chart 5A, a weekly chart of Adobe, shows that the stock rallied strongly from a low of about 15
dollars in mid 1998 to a high of about 75 dollars in late 1999. Note the characteristic cycle structure
during this trending phase; there is almost no overlap between adjacent cycles except for a brief
consolidation during the early part of 1999. However, starting in mid November 1999, Adobe begins
to retrace some of its gains. Upon closer examination of the daily chart during this phase (Chart 5B)
we see an overlapping cycle structure and a distinct 18-19 day cycle periodicity. Thus the action in
Adobe satisfies the basic requirements of the structure component of the model. Rather than attempt
to attribute various meanings to the shape of this pattern, we are simply looking for generic
behavior that is consistent with the model. Yet we are not ready to trade this pattern until we can
satisfy the requirement of the volatility component of the model. In Chart 5C, we can see how
relatively higher volatility, as denoted by ADX levels between 30 and 50 during the final months of
1999, coincided with a] the ending stages of the prior up-trend and b] the beginning stages of the
chart patterns development. Note also how decreasing volatility, as depicted by gradually declining
ADX levels, marked the late and final stages of chart pattern development. It is common to see ADX
levels decline into the sub20 level immediately prior to the completion of a chart pattern, just prior to
a pattern breakout, as Adobe demonstrates in January 2000. By waiting for the market to indicate
through a measurable decrease in relative volatility its readiness to breakout, and by ignoring the
directional implications of specific chart pattern shapes, we do not find ourselves engaged in the
tricky game of constantly anticipating the time of the breakout or its direction.




Chart 6A is a weekly chart of Ames Department Stores, showing prices in a steep downtrend from
mid June through November 1999. During this time Ames lost about fifty-percent of its value. Note
the rally attempt in November beginning from point X on the chart, and the slight pullback in
December to point Y. At this stage, on the heels of a multi-month decline in prices, a chartist might
normally be pondering whether this current pattern represents a higher low or some other popular
formation indicative of the early stages of a reversal. However, since we are only concerned with
whether and to what extent the pattern imitates the model, we do not refer to specific bull, bear or
pattern shapes. A closer look at the daily chart (Chart 6B) shows that Ames has established a
distinct 10-l 1 day cycle periodicity with clearly overlapping waves. Finally, in January of 2000, the
stock breaks down through support near 25 dollars (Chart 6C). Note how this pattern breakout
follows a decrease in relative volatility, as denoted by the ADX indicator declining into the sub20
level. Through an awareness of the conditions that precede pattern breakouts, we are less likely to
enter a position based on a premature or false move outside of the pattern. We are waiting for the
market to tell us when it is ready to move, rather than imputing our own biases to the pattern.
Lastly, Chart 7A shows a weekly chart of software maker Novell, with prices falling steadily from mid-
July through October 1999. Not unlike in the previous example of Ames Department Stores, Novell
loses roughly fifty-percent of its value over a multi-month period. Beginning in October, a period of
consolidation occurs in which a distinct 1415 day cycle emerges (Chart 7B). By mid-December, ADX
has declined to sub20 levels, a point at which we have normally come to expect a breakout (Chart
7C). Although I have highlighted the detail around this pattern to simulate a classically styled
complex or irregular head-and-shoulders bottom reversal, this was done purely in hindsight. The
point is that such interpretations are open to wide debate; no doubt many technicians could have
found different classical patterns in the chart prior to the upside resolution of prices in Novell in
December 1999.
FINAL THOUGHTS
Merely stating a technical observation does not elevate it to the status of eternal truth. Yet, distilling
our observations into strict rules also has its drawbacks; fixed rules inevitably fail to address the
exceptional cases. The conceptual model offers a possible middle ground. It attempts to remove
some of the subjectivity involved in chart pattern analysis while still permitting flexibility. The model is
useful, even if it is not always an absolute indicator, if it helps us to understand the nature of the
relationship between trending and non-trending markets, and how changes in volatility reflect
changes in overall supply and demand.
We have seen how higher volatility coincides with the early stages of chart pattern development and
declining volatility with the later stages. This has a logical basis: A more active market attracts and
supports more participants, and hence more gross supply and demand - or total investor interest -
than does a less active market. Any sudden changes in supply or demand in a less active or quiet
market can result in sharply higher or sharply lower quotes due to a sheer lack of available buyers or
sellers, hence resulting in what we commonly refer to as a pattern breakout. In the case of the
structure component, we have seen examples of how chart patterns, regardless of whether they be
reversal or continuation patterns in classical terms, can be set apart from trends by their
characteristic periodicity and wave structure.
If we accept the idea that classical chart patterns can be broadly characterized by general
conditions, rather than by a variety of pattern shapes, then perhaps classical chart patterns are
truly not the products of wishful or delusional thinking as some critics allege. Unlike UFOs, we can
point to evidence that supports chart pattern existence in the form of the volatility and structure
components. In addition, we can utilize this template view of chart pattern construction to help us
locate and trade patterns without debating over myriad chart pattern definitions and their directional
significance.
THANKS
Don Dillistone responded to my request for background information on charting and pointed me
towards specific resources in the MTA library; John McGinley also offered several suggestions.
Bruce Kamich graciously provided copies of out of print material by D.G. Worden. Alan M. Newman
provided copies of material by Gerhard Aschinger. Mike Moody offered help in verifying background
information.
FOOTNOTES
1. Fosback, Norman G. [ 19761. Stock Market Logic, Dearborn Financial Publishing, Inc., pp.
213214.
2. John Murphy, Louise Yamada, Alan Shaw, Justin Mamis, Ned Davis, Alex Saitta, Bruce
Kamich, Ralph Bloch, William ONeil, John Tirone, Peter Brandt - these names represent a
sample of well known market analysts and traders who utilize classical chart patterns.
3. Shaw, Alan R. [ 19881. Technical Analysis - reprintedfrom Financial Analyst? Handbook,
DowJones-Irwin, Inc., pp. 313.
4. Dines, James [ 19721. How the Average Investor Can Use Technical Analystifm Stock
Profits, Dines Chart Corp., pp. 171. Dines was paraphrasing - Worden, D. G., [date
unknown]. Article Tape Reading in an Old and New Key in the Encyclopedia of Stock
Market Techniques, pp. 820.
5. Murphy, John J. [ 19861. Technical Analpis of the Futures Markets, New York Inst. of
Finance, pp. 322-323.
6. Murphy, John J. [1986]. Technical Analysis of the Futures Markets, New Ymlz Inst.
@Finance, pp. 322-323.
7. Edwards, Robert D. and Magee, John [ 19921. Technical Analysis of Stock Trends, John
Magee Inc., pp.203.
8. Edwards, Franklin R. and Ma, Cindy W., [1992]. Futures and Options, McGraw-Hill, Inc., pp.
444.
9. Osler, C.L., and P.H. Kevin Chang [1995]. Head-and-shoulders: Notjust a flaky pattern,
paper, Federal Reserve Bank of New York, August.
10. Saitta, Alex [ 1998 1. Reversal Formations: Predictive Power?, article, Technical Analysis
of Stocks and Commodities, November.
11. Shaw, Alan R. [ 19881. Technical Analysis - repnntedfrom Financial Analysts Handbook,
Dow Jones-Irwin, Inc., pp. 316-317.
12. Koy, Kevin [1986]. The Big Hitters, Intermarket Publishing Corp., Interview with Robert
Prechter, pp.159.
13. Schabacker, Richard W. [ 19301. Stock Market Theory and Practice, B. C. Forbes
Publishing Co., pp. 626.
14. Roth, Phil [1997]. Technica& Speaking, interview, Traders Press, Inc., pp. 346.
15. Schabacker, Richard W. [ 19301. Stock Market Themy and Practice, B. C. Forbes
Publishing Co., pp. 601.
16. Schabacker, Richard W. [ 19321. Technical Analysis and Stock Market Profits, Pitman
Publishing, pp. 296.
17. In just one example, the headline of Louis Rukeysers March 1997 newsletter declares:
Leaving History to the Elves, This Markets Charting Its Own Course. Rukeyser goes on to
say in big, bold print The typical elf lives in the demonstrably vain hope that even-short
term market action is scientifically predictable, if only one can tweak the chart one more
time.
18. Schabacker, Richard M. [ 19301. Stock Market Theoq and Practice, B. C. Forbes
Publishing Co., pp, 658.
19. Schabacker, Richard W. [ 19341. Stock Murk&Pro&s, B. C. Forbes Publishing Co., pp. 101.
20. Schabacker, Richard W. [ 19341. Stock MurketPr@ts, B. C. Forbes Publishing Co., pp.
101.
21. Aschinger, Gerhard [ 19981. Reflections on the Crash, article in the Swiss Bank Corp.
journal: Economic and Financial Prospects, August/September issue.
22. Brandt, Peter L. [ 19901. Trading Commodity Futures with Classical Chart Patterns,
Advanced Trading Seminars, pp.1428.
23. In the literature of Schabacker, Wyckoff, Edwards and Magee, Jiller, Brandt et al., there is
general consensus that bar chart patterns are at best fallible as forecasting tools.
Schabacker connives to place above average confidence in the predictiveness of some
chart patterns, but not without disclaimers such as: . . .accurate analysis depends on
constant study, long experience and knowledge of all the fine points... (Stock Market
Profits, pp. 35.)
24. Lefevre, Edwin [ 19231, Reminiscences of a Stock Operator, John Wiley & Sons, Inc., pp.
125.
25. Gann, William D. [ 19231. The Truth of The Stock Tape, Financial Guardian Publishing Co.,
pp. 125.
26. In the book Martin Pring on Momentum, International Institute for Economic Research, [
19931, pp. 200, Pring gives an explanation of how ADX can be used to indicate declining
directional movement as a precursor to new market trends.
REFERENCES
Brandt, Peter L. [ 19901. Trading Commodity Futures with Classical Chart Patterns,
Advanced Trading Seminars
Dewey, Edward R. and Dakin, Edwin F., [ 19471. Cycles -The Set ence of Prediction, Henry
Holt & Company, Inc.
Dice, Charles A. and Eiteman, Wilford J. [ 19411. The Stock Mur- ket, McGraw-Hill, Inc.
Dines, James [ 19721. How the Average Investor Can Use Technical Analysis fw Stock
Profits, Dines Chart Corp.
Edwards, Franklin R. and Ma, Cindy W., [1992]. Futures and Options, McGraw-Hill, Inc.
Edwards, Robert D. and Magee, John [ 19921. Technical Analysis of Stock Trends, John
Magee Inc.
For@, Randall W., [April 28,1995]. Fed Gets Technical, Barrons, page MWIO, Dow Jones
& Co., Inc.
Fosback, Norman G. [ 19761. Stock Market Logic, Dearborn Financial Publishing, Inc.
Foster, Orline D. [1935]. The Art of Tape Reading Ticker Technique, Investors Press, Inc. -
1965 ed.
Frost, John and Prechter, Robert. [ 19781 Elliott Wave Principle, New Classics Library, Inc.
Gann, William D. [ 19231. The Truth of Tke Stock Tape, Financial Guardian Publishing Co.
Hamilton, William P. [ 19221. The Stock Market Barameter, Harper & Brothers Publishers.
Hurst, J. M. [ 19701. The Pn@ Magic of Stock Transaction Timing, Prentice-Hall, Inc.
Jiller, William L. [ 19671. How Charts Can Help You in The Stock Market, Trendline.
Kaufman, Perry J. [ 19871. The New Commodity Trading Systems and Methods, John
Wiley & Sons, Inc.
Koy, Kevin [ 19861. TheBigHittem, Intermarket Publishing Corp.
Lefevre, Edwin [ 19231. Reminiscences of a Stock @eratar, John Wiley & Sons, Inc.
Murphy, John J. [ 19861. Technical Analysis of the Futures Markets, New York Institute of
Finance.
Nixon, John Brooks, Jr. [ 19581. The Seven Fat Years: Chnmtiles of Wall Street, Harper &
Brothers Publishers.
Plummer, Tony [ 19891. The Psycho&y of Technical Analysis, Probus Publishing Company.
Pring, Martin J. [ 19931. Martin pring on Market Momentum, Institute for Economic
Research, Inc.
Schabacker, Richard W. [ 19301. Stock Market Theary and Practice, B. C. Forbes
Publishing Company.
Schabacker, Richard W. [ 19321. TechnicalAnalysis and Stock Market Pro@, Pitman
Publishing - 1997 ed.
Schabacker, Richard W. [ 19341. Stock Ma&tPn$ts, B. C. Forbes Publishing Company.
Schultz, Harry D. [1966]. A Treasury of Wall Street Wisdom, Investors Press, Inc.
Shaw, Alan R. [ 19881. Technical Analysis - m@intedfiDm Financial Analysts Handbook
Dow Jones-Irwin, Inc.
Sheimo, Michael - Michael Sheimo on Dow Theory- Technical Analvsis of Stocks &
Commodities, June 1998.
Sklarew, Arthur [ 19801. Techniques of a Professional Commodity Chart Analyst,
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Sperandeo, Victor [1991]. Trader Vie - Methods of a Wall Street Master, John Wiley &
Sons, Inc.
Pistolese, Clifford [ 19941. Using TechnicalAnalysis, McGraw-Hill, Inc.
Wilkinson, Chris [ 19971. Technically Speaking, Traders Press, Inc.
Wyckoff, Richard D. [ 19101. Studies in Tape Reading, Fraser Pub lishing Company,
Wyckoff/Stock Market Institute, Course Units 1 and 2. SMI, Phoenix, AZ tel: (609)-942-
5165.
BIOGRAPHY
After graduation from Babson College in 1988, Dan Chesler began his career as a cash commodity
trader, buying and selling in diverse markets ranging from industrial tomato paste to wheat and corn.
Dan joined the Louis Dreyfus Group of companies in 1992 as a price-risk manager where he helped
manage the worlds largest citrus products hedging and arbitrage program. In 1996 he worked as an
analyst and trading assistant for a medium sized, managed futures fund. Currently he is a partner in
a Miami based proprietary trading firm. Dan lives near Palm Beach, Florida

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