CORRELATION ANALYSIS

Overview
Correlation analysis measures the relationship between two items, for example, a security's price and an indicator. The resulting value (called the "correlation coefficient") shows if changes in one item (e.g., an indicator) will result in changes in the other item (e.g., the security's price).
Interpretation
When comparing the correlation between two items, one item is called the "dependent" item and the other the "independent" item. The goal is to see if a change in the independent item (which is usually an indicator) will result in a change in the dependent item (usually a security's price). This information helps you understand an indicator's predictive abilities.
The correlation coefficient can range between 1.0 (plus or minus one). A coefficient of +1.0, a "perfect positive correlation," means that changes in the independent item will result in an identical change in the dependent item (e.g., a change in the indicator will result in an identical change in the security's price). A coefficient of -1.0, a "perfect negative correlation," means that changes in the independent item will result in an identical change in the dependent item, but the change will be in the opposite direction. A coefficient of zero means there is no relationship between the two items and that a change in the independent item will have no effect in the dependent item.
A low correlation coefficient (e.g., less than 0.10) suggests that the relationship between two items is weak or non-existent. A high correlation coefficient (i.e., closer to plus or minus one) indicates that the dependent variable (e.g., the security's price) will usually change when the independent variable (e.g., an indicator) changes.
The direction of the dependent variable's change depends on the sign of the coefficient. If the coefficient is a positive number, then the dependent variable will move in the same direction as the independent variable; if the coefficient is negative, then the dependent variable will move in the opposite direction of the independent variable.
You can use correlation analysis in two basic ways: to determine the predictive ability of an indicator and to determine the correlation between two securities.
When comparing the correlation between an indicator and a security's price, a high positive coefficient (e.g., move then +0.70) tells you that a change in the indicator will usually predict a change in the security's price. A high negative correlation (e.g., less than -0.70) tells you that when the indicator changes, the security's price will usually move in the opposite direction. Remember, a low (e.g., close to zero) coefficient indicates that the relationship between the security's price and the indicator is not significant.
Correlation analysis is also valuable in gauging the relationship between two securities. Often, one security's price "leads" or predicts the price of another security. For example, the correlation coefficient of gold versus the dollar shows a strong negative relationship. This means that an increase in the dollar usually predicts a decrease in the price of gold.
Example
The following chart shows the relationship between corn and live hogs. The high correlation values show that, except during brief periods in February and May, there is a strong relationship between the price of these items (i.e., when the price of corn changes, the price of live hogs also moves in the same direction).

COMMODITY SELECTION INDEX

Overview
The Commodity Selection Index ("CSI") is a momentum indicator. It was developed by Welles Wilder and is presented in his book New Concepts in Technical Trading Systems.
The name of the index reflects its primary purpose. That is, to help select commodities suitable for short-term trading.
Interpretation
A high CSI rating indicates that the commodity has strong trending and volatility characteristics. The trending characteristics are brought out by the Directional Movement factor in the calculation--the volatility characteristic by the Average True Range factor.
Wilder's approach is to trade commodities with high CSI values (relative to other commodities). Because these commodities are highly volatile, they have the potential to make the "most money in the shortest period of time." High CSI values imply trending characteristics which make it easier to trade the security.
The Commodity Selection Index is designed for short-term traders who can handle the risks associated with highly volatile markets.
Example
The following chart shows the Japanese Yen and its 14-day CSI. Strong volatility and strong trends result in high CSI values at points "A" and "B."


Calculation
It is beyond the scope of this book to provide full calculation details on the Commodity Selection Index. It is calculated using the ADXR component of the Directional Movement indicator. Wilder's book New Concepts in Technical Trading Systems contains detailed information on the calculation of the CSI.

COMMODITY CHANNEL INDEX

Overview
The Commodity Channel Index ("CCI") measures the variation of a security's price from its statistical mean. High values show that prices are unusually high compared to average prices whereas low values indicate that prices are unusually low. Contrary to its name, the CCI can be used effectively on any type of security, not just commodities.
The CCI was developed by Donald Lambert.
Interpretation
There are two basic methods of interpreting the CCI: looking for divergences and as an overbought/oversold indicator.
• A divergence occurs when the security's prices are making new highs while the CCI is failing to surpass its previous highs. This classic divergence is usually followed by a correction in the security's price.

• The CCI typically oscillates between 100. To use the CCI as an overbought/oversold indicator, readings above +100 imply an overbought condition (and a pending price correction) while readings below -100 imply an oversold condition (and a pending rally).
Example
The following chart shows the British Pound and its 14-day CCI. A bullish divergence occurred at point "A" (prices were declining as the CCI was advancing). Prices subsequently rallied. A bearish divergence occurred at point "B" (prices were advancing while the CCI was declining). Prices corrected. Note too, that each of these divergences occurred at extreme levels (i.e., above +100 or below -100) making them even more significant.




Calculation
A complete explanation of the CCI calculation is beyond the scope of this book. The following are basic steps involved in the calculation:
1. Add each period's high, low, and close and divide this sum by 3. This is the typical price.
2. Calculate an n-period simple moving average of the typical prices computed in Step 1.
3. For each of the prior n-periods, subtract today's Step 2 value from Step 1's value n days ago. For example, if you were calculating a 5-day CCI, you would perform five subtractions using today's Step 2 value.
4. Calculate an n-period simple moving average of the absolute values of each of the results in Step 3.
5. Multiply the value in Step 4 by 0.015.
6. Subtract the value from Step 2 from the value in Step 1.
7. Divide the value in Step 6 by the value in Step 5.
Further details on the contents and interpretation of the CCI can be found in an article by Donald Lambert that appeared in the October 1980 issue of Commodities (now known as Futures) Magazine.

CHAIKIN OSCILLATOR

Overview
Inspired by the prior work of Joe Granville and Larry Williams, Marc Chaikin developed a new volume indicator, extending the work done by his predecessors. The Chaikin Oscillator is a moving average oscillator based on the Accumulation/Distribution indicator.
Interpretation
The following discussion of volume accumulation/distribution interpretation, written by Marc Chaikin, is reprinted here with his permission:
Technical analysis of both market averages and individual stocks must include volume studies in order to give the technician a true picture of the internal dynamics of a given market. Volume analysis helps in identifying internal strengths and weaknesses that exist under the cover of price action. Very often, volume divergences versus price movement are the only clues to an important reversal that is about to take place. While volume has always been mentioned by technicians as important, little effective volume work was done until Joe Granville and Larry Williams began to look at volume versus price in the late 1960s in a more creative way.
For many years it had been accepted that volume and price normally rose and fell together, but when this relationship changed, the price action should be examined for a possible change of trend. The Granville OBV concept which views the total volume on an up day as accumulation and the total volume on a down day as distribution is a decent one, but much too simplistic to be of value. The reason is that there are too many important tops and bottoms, both short-term and intermediate-term, where OBV confirms the price extreme. However, when an OBV line gives a divergence signal versus a price extreme, it can be a valuable technical signal and usually triggers a reversal in price.
Larry Williams took the OBV concept and improved on it. In order to determine whether there was accumulation or distribution in the market or an individual stock on a given day, Granville compared the closing price to the previous close, whereas Williams compared the closing price to the opening price. He [Williams] created a cumulative line by adding a percentage of total volume to the line if the close was higher than the opening and, subtracting a percentage of the total volume if the close was lower than its opening price. The accumulation/distribution line improved results dramatically over the classic OBV approach to volume divergences.
Williams then took this one step further in analyzing the Dow Jones Industrials by creating an oscillator of the accumulation/distribution line for even better buy and sell signals. In the early 1970s, however, the opening price for stocks was eliminated from the daily newspaper and Williams' formula became difficult to compute without many daily calls to a stockbroker with a quote machine. Because of this void, I created the Chaikin Oscillator substituting the average price of the day for Williams' opening and took the approach one step further by applying the oscillator to stocks and commodities. The Chaikin Oscillator is an excellent tool for generating buy and sell signals when its action is compared to price movement. I believe it is a significant improvement over the work that preceded it.
The premise behind my oscillator is three-fold. The first premise is that if a stock or market average closes above its midpoint for the day (as defined by [high + low] / 2), then there was accumulation on that day. The closer a stock or average closes to its high, the more accumulation there was. Conversely, if a stock closes below its midpoint for the day, there was distribution on that day. The closer a stock closes to its low, the more distribution there was.
The second premise is that a healthy advance is accompanied by rising volume and a strong volume accumulation. Since volume is the fuel that powers rallies, it follows that lagging volume on rallies is a sign of less fuel available to move stocks higher.
Conversely, declines are usually accompanied by low volume, but end with panic-like liquidation on the part of institutional investors. Thus, we look for a pickup in volume and then lower-lows on reduced volume with some accumulation before a valid bottom can develop.
The third premise is that by using the Chaikin Oscillator, you can monitor the flow of volume into and out of the market. Comparing this flow to price action can help identify tops and bottoms, both short-term and intermediate-term.
Since no technical approach works all the time, I suggest using the oscillator along with other technical indicators to avoid problems. I favor using a price envelope around a 21-day moving average and an overbought/oversold oscillator together with the Chaikin Oscillator for the best short and intermediate-term technical signals.
The most important signal generated by the Chaikin Oscillator occurs when prices reach a new high or new low for a swing, particularly at an overbought or oversold level, and the oscillator fails to exceed its previous extreme reading and then reverses direction.
1. Signals in the direction of the intermediate-term trend are more reliable than those against the trend.

2. A confirmed high or low does not imply any further price action in that direction. I view that as a non-event.
A second way to use the Chaikin Oscillator is to view a change of direction in the oscillator as a buy or sell signal, but only in the direction of the trend. For example, if we say that a stock that is above its 90-day moving average of price is in an uptrend, then an upturn of the oscillator while in negative territory would constitute a buy signal only if the stock were above its 90-day moving average--not below it.
A downturn of the oscillator while in positive territory (above zero) would be a sell signal if the stock were below its 90-day moving average of closing prices.

Example
The following chart shows Eastman Kodak and the Chaikin Oscillator. Bearish divergences (where prices increased to new highs while the Oscillator was falling) occurred at points "A" and "B." These divergences were warnings of the sell-offs that followed.




Calculation
The Chaikin Oscillator is created by subtracting a 10-period exponential moving average of the Accumulation/Distribution Line from a 3-period exponential moving average of the Accumulation/Distribution Line.

CANSLIM

Overview
CANSLIM is an acronym for a stock market investment method developed by William O'Neil. O'Neil is the founder and chairman of Investor's Business Daily, a national business newspaper. He also heads an investment research organization, William O'Neil & Company, Inc.
Drawing from his study of the greatest money-making stocks from 1953 to 1985, O'Neil developed a set of common characteristics that each of these stocks possessed. The key characteristics to focus on are captured in the acronym CANSLIM.

Current quarterly earnings per share
Annual earnings growth
New products, New Management, New Highs
Shares outstanding
Leading industry
Institutional sponsorship
Market direction

Although not strictly a technical analysis tool, the CANSLIM approach combines worthy technical and fundamental concepts. The CANSLIM approach is covered in detail in O'Neil's book, How To Make Money In Stocks.

Interpretation
The following text summarizes each of the seven components of the CANSLIM method.
Current Quarterly Earnings
Earnings per share ("EPS") for the most recent quarter should be up at least 20% when compared to the same quarter for the previous year (e.g., first quarter of 1993 to the first quarter of 1994).

Annual Earnings Growth
Earnings per share over the last five years should be increasing at the rate of at least 15% per year. Preferably, the EPS should increase each year. However, a single year set-back is acceptable if the EPS quickly recovers and moves back into new high territory.

New Products, New Management, New Highs
A dramatic increase in a stock's price typically coincides with something "new." This could be a new product or service, a new CEO, a new technology, or even new high stock prices.
One of O'Neil's most surprising conclusions from his research is contrary to what many investors feel to be prudent. Instead of adhering to the old stock market maxim, "buy low and sell high," O'Neil would say, "buy high and sell higher." O'Neil's research concluded that the ideal time to purchase a stock is when it breaks into new high territory after going through a two to 15 month consolidation period. Some of the most dramatic increases follow such a breakout, due possibly to the lack of resistance (i.e., sellers).

Shares Outstanding
More than 95% of the stocks in O'Neil's study of the greatest stock market winners had less than 25 million shares outstanding. Using the simple principles of supply and demand, restricting the shares outstanding forces the supply line to shift upward which results in higher prices.
A huge amount of buying (i.e., demand) is required to move a stock with 400 million shares outstanding. However, only a moderate amount of buying is required to propel a stock with only four to five million shares outstanding (particularly if a large amount is held by corporate insiders).

Leader
Although there is never a "satisfaction guaranteed" label attached to a stock, O'Neil found that you could significantly increase your chances of a profitable investment if you purchase a leading stock in a leading industry.
He also found that winning stocks are usually outperforming the majority of stocks in the overall market as well.

Institutional Sponsorship
The biggest source of supply and demand comes from institutional buyers (e.g., mutual funds, banks, insurance companies, etc). A stock does not require a large number of institutional sponsors, but institutional sponsors certainly give the stock a vote of approval. As a rule of thumb, O'Neil looks for stocks that have at least 3 to 10 institutional sponsors with better-than-average performance records.
However, too much sponsorship can be harmful. Once a stock has become "institutionalized" it may be too late. If 70 to 80 percent of a stock's outstanding shares are owned by institutions, the well may have run dry. The result of excessive institutional ownership can translate into excessive selling if bad news strikes.
O'Neil feels the ideal time to purchase a stock is when it has just become discovered by several quality institutional sponsors, but before it becomes so popular that it appears on every institution's hot list.

Market Direction
This is the most important element in the formula. Even the best stocks can lose money if the general market goes into a slump. Approximately seventy-five percent of all stocks move with the general market. This means that you can pick stocks that meet all the other criteria perfectly, yet if you fail to determine the direction of the general market, your stocks will probably perform poorly.
Market indicators are designed to help you determine the conditions of the overall market. O'Neil says, "Learn to interpret a daily price and volume chart of the market averages. If you do, you can't get too far off the track. You really won't need much else unless you want to argue with the trend of the market."

Neutral Patterns

Neutral Patterns

Neutral Patterns


Example
The following chart of Corn illustrates several Japanese candlestick patterns and principles.



You can see that advancing prices are usually accompanied with empty lines (prices opened low and closed higher) and that declines are accompanied with filled-in lines (prices opened high and closed lower).
Bearish engulfing lines occurred at points "A" and "B" (and prices subsequently moved lower). Bullish white lines occurred at points "1," "2," and "3" (as prices moved higher).

Reversal Patterns

Reversal Patterns

Bearish Patterns

Bearish Patterns

Bullish Patterns

Bullish Patterns

CANDLESTICKS - JAPANESE

Overview
In the 1600s, the Japanese developed a method of technical analysis to analyze the price of rice contracts. This technique is called candlestick charting. Steven Nison is credited with popularizing candlestick charting and has become recognized as the leading expert on their interpretation.
Candlestick charts display the open, high, low, and closing prices in a format similar to a modern-day bar-chart, but in a manner that extenuates the relationship between the opening and closing prices. Candlestick charts are simply a new way of looking at prices, they don't involve any calculations.
Each candlestick represents one period (e.g., day) of data. Figure 45 displays the elements of a candle.


Interpretation
I have met investors who are attracted to candlestick charts by their mystique--maybe they are the "long forgotten Asian secret" to investment analysis. Other investors are turned-off by this mystique--they are only charts, right? Regardless of your feelings about the heritage of candlestick charting, I strongly encourage you to explore their use. Candlestick charts dramatically illustrate changes in the underlying supply/demand lines.
Because candlesticks display the relationship between the open, high, low, and closing prices, they cannot be displayed on securities that only have closing prices, nor were they intended to be displayed on securities that lack opening prices. If you want to display a candlestick chart on a security that does not have opening prices, I suggest that you use the previous day's closing prices in place of opening prices. This technique can create candlestick lines and patterns that are unusual, but valid.
The interpretation of candlestick charts is based primarily on patterns. The most popular patterns are explained below.

BULL/BEAR RATIO

Overview
Each week a poll of investment advisors is taken and published by Investor's Intelligence of New Rochelle, New York. Investment advisors are tracked as to whether they are bullish, bearish, or neutral on the stock market. The Bull/Bear Ratio shows the relationship between the bullish and bearish advisors.
Interpretation
The Bull/Bear Ratio is a market sentiment indicator. Dr. Martin Zweig sums up sentiment indicators in his book Winning On Wall Street by saying, "Beware of the crowd when the crowd is too one-sided." Extreme optimism on the part of the public and even professionals almost always coincides with market tops. Extreme pessimism almost always coincides with market bottoms.
High readings of the Bull/Bear Ratio are bearish (there are too many bulls) and low readings are bullish (there are not enough bulls). In almost every case, extremely high or low readings have coincided with market tops or bottoms. Historically, readings above 60% have indicated extreme optimism (which is bearish for the market) and readings below 40% have indicated extreme pessimism (which is bullish for the market).
Example
The following chart shows the Bull/Bear Ratio and the S&P 500.



"Buy" arrows were drawn on the S&P 500 when the advisors were extremely bearish and "sell" arrows were drawn when advisors were extremely bullish.
Calculation
The Bull/Bear Ratio is calculated by dividing the number of bullish advisors by the number of bullish plus bearish advisors. The number of neutral advisors is ignored.

BREADTH THRUST

Overview
The Breadth Thrust indicator is a market momentum indicator. It was developed by Dr. Martin Zweig. The Breadth Thrust is calculated by dividing a 10-day exponential moving average of the number of advancing issues, by the number of advancing plus declining issues.
Interpretation
A "Breadth Thrust" occurs when, during a 10-day period, the Breadth Thrust indicator rises from below 40% to above 61.5%. A "Thrust" indicates that the stock market has rapidly changed from an oversold condition to one of strength, but has not yet become overbought.
According to Dr. Zweig, there have only been fourteen Breadth Thrusts since 1945. The average gain following these fourteen Thrusts was 24.6% in an average time-frame of eleven months. Dr. Zweig also points out that most bull markets begin with a Breadth Thrust.
Example
The following chart shows the S&P 500 and the Breadth Thrust indicator.


Horizontal lines are drawn on the Breadth Thrust indicator at 40.0% and 61.5%. Remember that a Thrust occurs when the indicator moves from below 40% to above 61.5% during a 10 day period.
On December 18, 1984, I wrote the following comment regarding the Breadth Thrust indicator in a software manual:
"At the time this discussion on the Breadth Thrust is being written (12/18/84), the NYSE has gained only 1.6% since the 'Thrust.' If the market fails to go higher in the next six to twelve months, it will be the first false signal generated by the Breadth Thrust indicator in 39 years! With historical average gains of almost 25%, we feel the odds are in our favor when we go with the Thrust."
As shown in the example, the NYSE did in fact go higher in the ensuing months. Twelve months after the Thrust occurred the NYSE was up 21.6%. Twenty-one months after the Thrust occurred, the NYSE was up a whopping 51%. Trust the next thrust...
Calculation
The Breadth Thrust is a 10-day simple moving average of the following:

BOLLINGER BANDS

Overview
Bollinger Bands are similar to moving average envelopes. The difference between Bollinger Bands and envelopes is envelopes are plotted at a fixed percentage above and below a moving average, whereas Bollinger Bands are plotted at standard deviation levels above and below a moving average. Since standard deviation is a measure of volatility, the bands are self-adjusting: widening during volatile markets and contracting during calmer periods.
Bollinger Bands were created by John Bollinger.
Interpretation
Bollinger Bands are usually displayed on top of security prices, but they can be displayed on an indicator. These comments refer to bands displayed on prices.
As with moving average envelopes, the basic interpretation of Bollinger Bands is that prices tend to stay within the upper- and lower-band. The distinctive characteristic of Bollinger Bands is that the spacing between the bands varies based on the volatility of the prices. During periods of extreme price changes (i.e., high volatility), the bands widen to become more forgiving. During periods of stagnant pricing (i.e., low volatility), the bands narrow to contain prices.
Mr. Bollinger notes the following characteristics of Bollinger Bands.
• Sharp price changes tend to occur after the bands tighten, as volatility lessens.
• When prices move outside the bands, a continuation of the current trend is implied.
• Bottoms and tops made outside the bands followed by bottoms and tops made inside the bands call for reversals in the trend.
• A move that originates at one band tends to go all the way to the other band. This observation is useful when projecting price targets.
Example
The following chart shows Bollinger Bands on Exxon's prices.


The Bands were calculated using a 20-day exponential moving average and are spaced two deviations apart.
The bands were at their widest when prices were volatile during April. They narrowed when prices entered a consolidation period later in the year. The narrowing of the bands increases the probability of a sharp breakout in prices. The longer prices remain within the narrow bands the more likely a price breakout.
Calculation
Bollinger Bands are displayed as three bands. The middle band is a normal moving average. In the following formula, "n" is the number of time periods in the moving average (e.g., 20 days).



The upper band is the same as the middle band, but it is shifted up by the number of standard deviations (e.g., two deviations). In this next formula, "D" is the number of standard deviations.



The lower band is the moving average shifted down by the same number of standard deviations (i.e., "D").



Mr. Bollinger recommends using "20" for the number of periods in the moving average, calculating the moving average using the "simple" method (as shown in the formula for the middle band), and using 2 standard deviations. He has also found that moving averages of less then 10 periods do not work very well.

AVERAGE TRUE RANGE

Overview
The Average True Range ("ATR") is a measure of volatility. It was introduced by Welles Wilder in his book, New Concepts in Technical Trading Systems, and has since been used as a component of many indicators and trading systems.
Interpretation
Wilder has found that high ATR values often occur at market bottoms following a "panic" sell-off. Low Average True Range values are often found during extended sideways periods, such as those found at tops and after consolidation periods.
The Average True Range can be interpreted using the same techniques that are used with the other volatility indicators. Refer to the discussion on Standard Deviation for additional information on volatility interpretation.
Example
The following chart shows McDonald's and its Average True Range.



This is a good example of high volatility as prices bottom (points "A" and "A'") and low volatility as prices consolidate prior to a breakout (points "B" and "B'").
Calculation
The True Range indicator is the greatest of the following:
• The distance from today's high to today's low.
• The distance from yesterday's close to today's high.
• The distance from yesterday's close to today's low.
The Average True Range is a moving average (typically 14-days) of the True Ranges.

ARMS INDEX

Overview
The Arms Index is a market indicator that shows the relationship between the number of stocks that increase or decrease in price (advancing/declining issues) and the volume associated with stocks that increase or decrease in price (advancing/declining volume). It is calculated by dividing the Advance/Decline Ratio by the Upside/Downside Ratio.
The Arms Index was developed by Richard Arms in 1967. Over the years, the index has been referred to by a number of different names. When Barron's published the first article on the indicator in 1967, they called it the Short-term Trading Index. It has also been known as TRIN (an acronym for TRading INdex), MKDS, and STKS.
Interpretation
The Arms Index is primarily a short-term trading tool. The Index shows whether volume is flowing into advancing or declining stocks. If more volume is associated with advancing stocks than declining stocks, the Arms Index will be less than 1.0; if more volume is associated with declining stocks, the Index will be greater than 1.0.
The Index is usually smoothed with a moving average. I suggest using a 4-day moving average for short-term analysis, a 21-day moving average for intermediate-term, and a 55-day moving average for longer-term analysis.
Normally, the Arms Index is considered bullish when it is below 1.0 and bearish when it is above 1.0. However, the Index seems to work most effectively as an overbought/oversold indicator. When the indicator drops to extremely overbought levels, it is foretelling a selling opportunity. When it rises to extremely oversold levels, a buying opportunity is approaching.
What constitutes an "extremely" overbought or oversold level depends on the length of the moving average used to smooth the indicator and on market conditions. Table 5 shows typical overbought and oversold levels.



Example
The following chart contains a 21-day moving average of the Arms Index and the New York Stock Exchange Index.


Horizontal lines are drawn at the oversold level of 1.08 and at the overbought level of 0.85. I drew "buy" arrows when the Arms Index peaked above 1.08 and "sell" arrows when the Index bottomed below 0.85. In most of the cases the arrows occur at, or one day before, significant changes in price.
Calculation
The Arms Index is calculated by first dividing the number of stocks that advanced in price by the number of stocks that declined in price to determine the Advance/Decline Ratio. Next, the volume of advancing stocks is divided by the volume of declining stocks to determine the Upside/Downside Ratio. Finally, the Advance/Decline Ratio is divided by the Upside/Downside Ratio.

ANDREWS' PITCHFORK

Overview
Andrews' Pitchfork is a line study consisting of three parallel trend lines based on three points you select. This tool was developed by Dr. Alan Andrews.
Interpretation
The interpretation of a pitchfork is based on normal trend line support and resistance principles.
Example
The following chart of Xerox shows an Andrews' Pitchfork.



The pitchfork was displayed by selecting the three points shown. You can see how prices tended to "walk along" the trend lines.
Calculation
The first trend line begins at the left-most point selected (either a major peak or trough) and is drawn so it passes directly between the two right-most points. This line is the "handle" of the pitchfork. The second and third trend lines are then drawn beginning at the two right-most points (a major peak and a major trough) and are drawn parallel to the first line. These lines are the "tines" of the pitchfork.

ADVANCING, DECLINING, UNCHANGED VOLUME

Overview
Advancing, declining, and unchanged volume are all market momentum indicators. They reflect movement on the New York Stock exchange in millions of shares.
Advancing volume is the total volume for all securities that advanced in price. Declining volume is the total volume for all securities that declined in price. And similarly, unchanged volume is the total volume for all securities that were unchanged in price.
Interpretation
Numerous indicators have been developed using up and down volume indicators. These indicators include the Cumulative Volume Index, Negative Volume Index, Positive Volume Index, and the Upside-Downside Ratio. Charts of the advancing or declining volume can be used to look for volume divergences (where advancing volume increases but the market falls) to see if selling pressure is waning, to view daily trends, etc.
Due to the erratic fluctuations in advancing and declining volume, I suggest you smooth the indicators with a 3- to 10-day moving average.
Example
The following chart shows the S&P 500 and a 10-day moving average of advancing volume.



A bearish divergence developed as prices tried to rally (trend line "A") while the advancing volume was declining (trend line "B"). If you only looked at the S&P 500 you might think the market was gaining strength. The Advancing Volume showed the true picture and prices were forced to correct.

ADVANCING-DECLINING ISSUES

Overview
The Advancing-Declining Issues is a market momentum indicator which shows the difference between stocks listed on the New York Stock Exchange that advanced in price minus those that declined. As of this writing, about 2,500 issues trade each day on the NYSE.
The difference between the number of advancing and declining issues is the foundation of many market breadth indicators. These indicators include the Advance/Decline Line, Advance/Decline Ratio, Absolute Breadth Index, Breadth Thrust, McClellan Oscillator and Summation Index. Indicators that use advancing and declining issues in their calculations are called market breadth indicators.
Interpretation
The Advancing-Declining Issues indicator shows the difference between the number of advancing issues and the number of declining issues. Plotted by itself, this indicator is helpful to determine daily market strength. Strong up days generally show readings of more than +1,000. Very weak days have readings of less than -1,000.
I prefer to plot a 5-to-40 day exponential moving average of the Advancing-Declining Issues rather than the daily values themselves. The moving average creates an excellent short-term overbought/oversold indicator. Both the Over-bought/-Oversold indicator and the McClellan Oscillator are created using moving averages of advancing minus declining issues.
Example
The following chart shows the DJIA and a 40-day moving average of the Advancing-Declining Issues indicator.



I drew "buy" arrows when the moving average rose above -50 and "sell" arrows when it fell below 125. Normally, I would use 100, but the strong up-trend during this period caused the indicator to have an upward bias.
Calculation
The Advancing-Declining Issues is calculated simply by subtracting the number of declining issues from the number of advancing issues.



The following table shows the calculation of the Advancing-Declining Issues.

ADVANCE/DECLINE RATIO

Overview
The Advance/Decline Ratio ("A/D Ratio") shows the ratio of advancing issues to declining issues. It is calculated by dividing the number of advancing issues by the number of declining issues.

Interpretation
The A/D Ratio is similar to the Advancing-Declining Issues in that it displays market breadth. But, where the Advancing-Declining Issues subtracts the advancing/declining values, the A/D Ratio divides the values. The advantage of the Ratio is that it remains constant regardless of the number of issues that are traded on the New York Stock Exchange (which has steadily increased).
A moving average of the A/D Ratio is often used as an overbought/oversold indicator. The higher the value, the more "excessive" the rally and the more likely a correction. Likewise, low readings imply an oversold market and suggest a technical rally.
Keep in mind, however, that markets that appear to be extremely overbought or oversold may stay that way for some time. When investing using overbought and oversold indicators, it is wise to wait for the prices to confirm your belief that a change is due before placing your trades.
Day-to-day fluctuations of the Advance/Decline Ratio are often eliminated by smoothing the ratio with a moving average.

Example
The following chart shows the S&P 500 and a 15-day moving average of the A/D Ratio.



You can see that prices usually declined after entering the overbought level above 1.25 ("sell" arrows) and that they usually rallied after entering the oversold level below 0.90 ("buy" arrows).

Calculation
The A/D Ratio is calculated by dividing the number of stocks that advanced in price for the day by the number of stocks that declined.



Table 3 shows the calculation of the A/D Ratio.

ADVANCE/DECLINE LINE

Overview
The Advance/Decline Line ("A/D Line") is undoubtedly the most widely used measure of market breadth. It is a cumulative total of the Advancing-Declining Issues indicator. When compared to the movement of a market index (e.g., Dow Jones Industrials, S&P 500, etc) the A/D Line has proven to be an effective gauge of the stock market's strength.

Interpretation
The A/D Line is helpful when measuring overall market strength. When more stocks are advancing than declining, the A/D Line moves up (and vice versa).
Many investors feel that the A/D Line shows market strength better than more commonly used indices such as the Dow Jones Industrial Average ("DJIA") or the S&P 500 Index. By studying the trend of the A/D Line you can see if the market is in a rising or falling trend, if the trend is still intact, and how long the current trend has prevailed.
Another way to use the A/D Line is to look for a divergence between the DJIA (or a similar index) and the A/D Line. Often, an end to a bull market can be forecast when the A/D Line begins to round over while the DJIA is still trying to make new highs. Historically, when a divergence develops between the DJIA and the A/D Line, the DJIA has corrected and gone the direction of the A/D Line.
A military analogy is often used when discussing the relationship between the A/D Line and the DJIA. The analogy is that trouble looms when the generals lead (e.g., the DJIA is making new highs) and the troops refuse to follow (e.g., the A/D Line fails to make new highs).

Example
The following chart shows the DJIA and the A/D Line.



The DJIA was making new highs during the 12 months leading up to the 1987 crash. During this same period, the A/D Line was failing to reach new highs. This type of divergence, where the generals lead and the troops refuse to follow, usually results in the generals retreating in defeat as happened in 1987.
Calculation




Because the A/D Line always starts at zero, the numeric value of the A/D Line is of little importance. What is important is the slope and pattern of the A/D Line.

ACCUMULATION SWING INDEX

Overview
The Accumulation Swing Index is a cumulative total of the Swing Index. The Accumulation Swing Index was developed by Welles Wilder.
Interpretation
Mr. Wilder said, "Somewhere amidst the maze of Open, High, Low and Close prices is a phantom line that is the real market." The Accumulation Swing Index attempts to show this phantom line. Since the Accumulation Swing Index attempts to show the "real market," it closely resembles prices themselves. This allows you to use classic support/resistance analysis on the Index itself. Typical analysis involves looking for breakouts, new highs and lows, and divergences.
Wilder notes the following characteristics of the Accumulation Swing Index:
• It provides a numerical value that quantifies price swings.

• It defines short-term swing points.

• It cuts through the maze of high, low, and close prices and indicates the real strength and direction of the market.

Example
The following chart shows Corn and its Accumulation Swing Index.



You can see that the breakouts of the price trend lines labeled "A" and "B" were confirmed by breakouts of the Accumulation Swing Index trend lines labeled "A'" and "B'."
Calculation
The Accumulation Swing Index is a cumulative total of the Swing Index. The Swing Index and the Accumulation Swing Index require opening prices.
Step-by-step instructions on calculating the Swing Index are provided in Wilder's book, New Concepts In Technical Trading Systems.

ACCUMULATION/DISTRIBUTION

Overview
The Accumulation/Distribution is a momentum indicator that associates changes in price and volume. The indicator is based on the premise that the more volume that accompanies a price move, the more significant the price move.

Interpretation
The Accumulation/Distribution is really a variation of the more popular On Balance Volume indicator. Both of these indicators attempt to confirm changes in prices by comparing the volume associated with prices.
When the Accumulation/Distribution moves up, it shows that the security is being accumulated, as most of the volume is associated with upward price movement. When the indicator moves down, it shows that the security is being distributed, as most of the volume is associated with downward price movement.
Divergences between the Accumulation/Distribution and the security's price imply a change is imminent. When a divergence does occur, prices usually change to confirm the Accumulation/Distribution. For example, if the indicator is moving up and the security's price is going down, prices will probably reverse.

Example
The following chart shows Battle Mountain Gold and its Accumulation /Distribution.



Battle Mountain's price diverged as it reached new highs in late July while the indicator was falling. Prices then corrected to confirm the indicator's trend.

Calculation
A portion of each day's volume is added or subtracted from a cumulative total. The nearer the closing price is to the high for the day, the more volume added to the cumulative total. The nearer the closing price is to the low for the day, the more volume subtracted from the cumulative total. If the close is exactly between the high and low prices, nothing is added to the cumulative total.

ABSOLUTE BREADTH INDEX

Overview
The Absolute Breadth Index ("ABI") is a market momentum indicator that was developed by Norman G. Fosback.
The ABI shows how much activity, volatility, and change is taking place on the New York Stock Exchange while ignoring the direction prices are headed.

Interpretation
You can think of the ABI as an "activity index." High readings indicate market activity and change, while low readings indicate lack of change.
In Fosback's book, Stock Market Logic, he indicates that historically, high values typically lead to higher prices three to twelve months later. Fosback found that a highly reliable variation of the ABI is to divide the weekly ABI by the total issues traded. A ten-week moving average of this value is then calculated. Readings above 40% are very bullish and readings below 15% are bearish.

Example
The following chart shows the S&P 500 and a 5-week moving average of the ABI.



Strong rallies occurred every time the ABI's moving average rose above 310.

Calculation
The Absolute Breadth Index is calculated by taking the absolute value of the difference between NYSE Advancing Issues and NYSE Declining Issues.


Absolute value (i.e., ABS) means "regardless of sign." Thus, the absolute value of -100 is 100 and the absolute value of +100 is also 100.

The Time Element

The discussion that began on page explained the open, high, low, and closing price fields. This section presents the time element.
Much of technical analysis focuses on changes in prices over time. Consider the effect of time in the following charts, each of which show a security's price increase from $25 to around $45.
Figure 43 shows that Merck's price increased consistently over a 12-month time period. This chart shows that investors continually reaffirmed the security's upward movement.


As shown in Figure 44, Disney's price also moved from around $25 to $45, but it did so in two significant moves. This shows that on two occasions investors believed the security's price would move higher. But following the first bidding war, a period of time had to pass before investors accepted the new prices and were ready to move them higher.



The pause after the rapid increase in Disney's price is a typical phenomena. People have a difficult time accepting new prices suddenly, but will accept them over time. What once looked expensive may one day look cheap as expectations evolve.
This is an interesting aspect of point and figure charts, because point and figure charts totally disregard the passage of time and only display changes in price.

A Sample Approach
There are many technical analysis tools in this book. The most difficult part of technical analysis may be deciding which tools to use! Here is an approach you might try.

1. Determine the overall market condition.
If you are trading equity-based securities (e.g., stocks), determine the trend in interest rates, the trend of the New York Stock Exchange, and of investor sentiment (e.g., read the newspaper). The object is to determine the overall trend of the market.

2. Pick the securities.
I suggest that you pick the securities using either a company or industry you are familiar with, or the recommendation of a trusted analyst (either fundamental or technical).

3. Determine the overall trend of the security.
Plot a 200-day (or 39-week) moving average of the security's closing price. The best buying opportunities occur when the security has just risen above this long-term moving average.

4. Pick your entry points.
Buy and sell using your favorite indicator. However, only take positions that agree with overall market conditions.

Much of your success in technical analysis will come from experience. The goal isn't to find the holy grail of technical analysis, it is to reduce your risks (e.g., by trading with the overall trend) while capitalizing on opportunities (e.g., using your favorite indicator to time your trades). As you gain experience, you will make better, more informed, and more profitable investments.
"A fool sees not the same tree that a wise man sees."- William Blake, 1790

Periodicity

Regardless of the "periodicity" of the data in your charts (i.e., hourly, daily, weekly, monthly, etc), the basic principles of technical analysis endure. Consider the following charts of a Swiss Franc contract shown in Figures 40, 41, and 42.







Typically, the shorter the periodicity, the more difficult it is to predict and profit from changes in prices. The difficulty associated with shorter periodicities is compounded by the fact that you have less time to make your decisions.
"While we stop and think, we often miss our opportunity."- Publilius Syrus, 1st century B.C.
Opportunities exist in any time frame. But I have rarely met a successful short-term trader who wasn't also successful a long-term investor. And I have met many investors who get caught by the grass-is-greener syndrome believing that shorter-and-shorter time periods is the secret to making money--it isn't.

Line Studies

Line studies are technical analysis tools that consist of lines drawn on top of a security's price and/or indicator. These include the support, resistance, and trend line concepts already discussed.