INTRODUCTION DEFINITION. What does Technical Analysis mean?

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1 Chapter 1 Chapter 2 INTRODUCTION DEFINITION The methods used to analyze securities and make investment decisions fall into two very broad categories: fundamental analysis and technical analysis. Fundamental analysis involves analyzing the characteristics of a company in order to estimate its value. Technical analysis takes a completely different approach; it doesn't care one bit about the "value" of a company or a commodity. Technicians (sometimes called chartists) are only interested in the price movements in the market. Despite all the fancy and exotic tools it employs, technical analysis really just studies supply and demand in a market in an attempt to determine what direction or trend will continue in the future. In other words, technical analysis attempts to understand the emotions in the market by studying the market itself, as opposed to its components. If you understand the benefits and limitations of technical analysis, it can give you a new set of tools or skills that will enable you to be a better trader or investor. In this tutorial, we'll introduce you to the subject of technical analysis. It's a broad topic, so we'll just cover the basics, providing you with the foundation you'll need to understand more advanced concepts down the road. What does Technical Analysis mean? Technical analysis is a method of evaluating securities by analyzing the statics generated by market activity, such as past prices and volume. Technical analysts do not attempt to measure a security s intrinsic, value, but instead use charts and other tools to identify patterns that can suggest activity. Just as there are many investment styles on the fundamental side, there also many different types of technical traders. Some rely on chart patterns, other use technical indicators and oscillators, and most use some combination of the two. In any case, technical analysis exclusive use of historical price and volume data is what separates them from their fundamental counterparts. Unlike fundamental analysts, technical analysis do not care whether a stock is undervalued the only thing that matters is a security s past trading data and what information this data can provide about where the security might move in the future. The purpose of technical analysis is identify trend changes that precede the fundamental trend and do not (yet) make sense if compared to the concurrent fundamental trends. According to Wikipedia the free encyclopedia, Technical analysis is a security analysis discipline for forecasting the future direction of prices through the study post market data, primarily price and volume {1}. In its purest form, technical analysis considers only the actual price and volume behavior of the market or investment. Investopedia explains Technical analysis as Technical analysts believe that the historical performance of stocks and markets are indications of future performance. It further explains the same with the help of the following example: In a shopping mall, a fundamental analyst would go to each store, study the product that was being sold, and then decide whether to buy it or not. By contrast, a technical analyst would sit on a bench in the mall and watch people go into the stores. Disregarding the intrinsic value of the products in the store, his or her decision would be based on the patterns or activity of people going into each store. Figure

2 Chapter 3 PRINCIPLES Application of Technical Analysis: Stock charts us a lot about what companies are doing, what they will be doing and what the markets thinks of it all. However, we have to learn how to read the stock charts. At the most basics level, there are some important concepts that should be kept mind: Uptrends are characterized by rising bottoms on the stock chart and can be described as periods of optimism. Downtrends are characterized by falling tops on the stock charts, and can be described as periods of pessimism. Abnormal trading activity often signals significant fundamental change in the company s business. Support is a floor price that the market has shown an unwillingness to trade under in the past. Resistance is a ceiling price that the market has shown unwillingness to trade above in the past. Note: in the same manner compute the DPO and DIO. Technicians say that a markets s price reflects all relevant informations, so their analysis looks more at internals than at externals such as news events. Price action also tends to repeat itself because investors collectively tend toward patterned behavior hence technicians focus on identifiable trends and condition. The study of technical analysis is based on the following three broad principles: The Market Discounts Everything A major criticism of technical analysis is that it only considers price movement, ignoring the fundamental factors of the company. However, technical analysis assumes that, at given time, a stock s price reflects everything that has or could affect the company including fundamental factors. Technical analysts believe that the company s fundamentals, along with broader economic factors and market psychology, are all priced into the stock, removing the need to actually consider these factors separately. This only leaves the analysis of price movement, which technical theory views as a product of the supply and dement for particular stock in the market. Price Moves in Trend In technical analysis, price movements are believed to follow trends. This means that after a trend has been established, the future price movement is more likely to be in the same direction as the trend that to be against it. Most technical trading strategies are based on this assumption. History Tends To Repeat Itself Another important idea in technical analysis is that history tends to repeat itself, mainly in terms of price movement. The repetitive nature of price movements is attributed to market psychology; in other words, market participants tend to provide a consistent reaction to similar market stimuli over time. Technical analysis uses chart patterns to analyze market movements and understand trends. Although many of there charts have been used for more than 100 years, they are still believed to be relevant because they illustrate patterns in price movements that often repeat themselves. Not Just for Stocks Technical analysis can be used on any security with historical trading data. This includes stocks, futures and commodities, fixed-income securities, forex, etc. In this tutorial, we ll usually analyze stocks in our examples, but keep in mind that these concepts can be applied to any type of security. In fact, technical analysis is more frequently associated with commoditized and forex, where the participants are predominantly traders. 3 4

3 Chapter 4 FUNDAMENTAL ANALYSIS VS. TECHNICAL ANALYSIS The fundamentalist studies the cause of the market movements while the technicians studies the effect John Murphy Technical analysis and fundamental analysis are the two main schools of thought in the financial markets. As mentioned earlier, technical analysis looks at the price movement of a security and used this data to predict its future price movements. Fundamental analysis, on the other hand, looks at economic factors, known as fundamentals. Let s get into the details of how these two approaches differ, the criticism against technical analysis and how technical and fundamental analysis can be used together to analyze securities. Charts vs. Financial Statements At the most basic level, a technical analyst approaches a security from the charts, while a fundamental analyst starts with the financial statements. By looking at the balance sheet, cash flow statements and income statement, a fundamental analyst tries to determine a company s value. In future terms, an analyst attempts to measure a company s intrinsic value. In this approach, investment decisions are fairly easy to make if the price of a stock trades below its intrinsic value, it s a good investment. Technical traders, on the other hand, believe there is no reason to analyze a company s fundamentals because there are all accounted for in the stock s price. Technicians believe that all the information they need about a stock can be found in its charts. The different timeframes that these two approaches use is a result of the nature of the investing style to which they each adhere. It can take a long time for a company's value to be reflected in the market, so when a fundamental analyst estimates intrinsic value, a gain is not realized until the stock's market price rises to its "correct" value. This type of investing is called value investing and assumes that the short-term market is wrong, but that the price of a particular stock will correct itself over the long run. This "long run" can represent a timeframe of as long as several years, in some cases. Furthermore, the numbers that a fundamentalist analyzes are only released over long periods of time. Financial statements are filed quarterly and changes in earnings per share do not emerge on a daily basis like price and volume information. Also remember that fundamentals are the actual characteristics of a business. New management cannot implement sweeping changes overnight and it takes time to create new products, marketing campaigns, supply chains, etc. Part of the reason that fundamental analysts use a long-term timeframe, therefore, is because the data they use to analyze a stock is generated much more slowly than the price and volume data used by technical analysts. Trading Versus Investing Not only is technical analysis more short term in nature than fundamental analysis, but the goals of a purchase (or sale) of a stock are usually different for each approach. In general, technical analysis is used for trading, whereas fundamental analysis is used to make an investment. Investors buy assets they believe can increase in value, while traders buy assets they believe they can sell to somebody else at a greater price. The line between a trade and an investment can be blurry, but it does characterize a difference between the two schools. Time Horizon Fundamental analysis takes a relatively long-term approach in analyzing the market compared to technical analysis. While technical analysis can be used on a timeframe of weeks, days or even minutes, fundamental analysis often looks at data over a number of years. 5 6

4 Chapter 5 Chapter 6 TECHNICAL ANALYSIS PRE-EMPTS FUNDAMENTAL ANALYSIS INVESTORS' PSYCHOLOGY Fundamentalists believe that there is a cause and effect between fundamental factors and price changes. This means that if the fundamental news is positive, the price should rise, whereas if the news is negative, the price should fall. However, longterm analyses of price changes in financial markets globally show that such a correlation is present only in the short-term horizon and only to a limited extent. It is non-existent on both the medium-term and long-term basis. G R E E D F E A R However, the contrary is true. The stock market itself is the best predictor of the future fundamental trend. Most often, prices start rising in a new bull trend while the economy is still in recession (as depicted by position B on chart shown below), i.e. while there is no cause for such an uptrend. As against this, prices start falling in a new bear trend while the economy is still growing (as depicted by position A on the chart below), and not providing fundamental reasons to sell. There is a time-lag of several months by which the fundamental trend follows the stock market trend. Moreover, this is not only true for the stock market and the economy alone but also for the price trends of individual equities and company earnings. Stock prices peak ahead of peak earnings while bottoming ahead of peak losses. The purpose of technical analysis is to identify trend changes that precede the fundamental trend and do not (yet) make sense if compared to the concurrent fundamental trend.(line repeated from pg 6) There are many characteristics and skills required by investors/ traders in order to be successful in the - financial markets. The ability to understand the inner workings of a company, its fundamentals and the ability to determine the direction of the trend are a few of the key traits needed, but none of these is as important as the ability to contain emotions and maintain discipline. The psychological aspect of investing / trading is extremely important, and the reason for that is fairly simple. Investors/ traders often dart in and out of stocks on short notice, and are forced to make quick decisions. To accomplish this, they need a certain presence of mind. They also, by extension, need discipline, so that they stick to the previously established trading plans and know when to book profits and losses. Emotions simply cannot get in their way. In this context, the following must be made a note of: Mood is stronger than ratio "Know yourself and knowledge of the stock market will soon follow" - Ego and emotions determine far more of investors' stock market decisions than most would be willing to admit. For years, we have dealt with professional money managers and investment committees and have found that they were as much subject to crowd following and other irrational emotional mistakes as a novice investor. Despite being well informed, facts alone do not help individuals to make profitable decisions. The human element, which encompasses a range of emotions from fear to greed, plays a much bigger role in the decision making process than most investors realize. On the contrary, most investors act exactly in the opposite manner to the rational wisdom of buying low and selling high based on very predictable emotional responses to rising or falling prices. Falling prices that at first appear to be bargains generate fear of loss at much lower prices when opportunities are the greatest. Rising prices that at first appear to be good opportunities to sell ultimately lead to greed-induced buying at much higher levels. Here, reason is replaced by emotion and respective rationalization with such cyclical regularity, that those who recognize the symptoms and the trend changes on the charts can profit very well from this knowledge. 7 8

5 Chapter 7 TREND & TRENDLINES Optimism and pessimism - greed and fear People are motivated by greed (optimism) while buying and by fear (pessimism) while selling. They are motivated to buy and sell by changes in emotion from optimism to pessimism and vice versa. They formulate fundamental scenarios based on their emotional state (a rationalization of the emotions), which prevents them from realizing that the main drive is emotion. DEFINITION A "trend" can be defined as the general direction of a market or of the price of an asset. Trends can vary in length from short, to intermediate, to long term. If one can identify a trend, it can be highly profitable, because he / she will be able to trade with the trend. The chart below shows that if investors buy on the basis of confidence or conviction (optimism), they BUY near or at the TOP. Likewise, if investors act on concern or capitulation (pessimism), they SELL near or at the BOTTOM. Investors remain under the bullish impression of the recent uptrend beyond the forming price top and during a large part of the bear trend. As against this, they remain pessimistic under the bearish impression from the past downtrend through the market bottom and during a large part of the next bull trend. They adjust their bullish fundamental scenarios to bearish AFTER having become pessimistic under the pressure of the downtrend or AFTER having become optimistic under the pressure of the uptrend. Once having turned bearish, investors formulate bearish scenarios, looking for more weakness just when it is about time to buy again. The same occurs in an uptrend when mood shifts from pessimism to optimism. Investors formulate bullish scenarios AFTER having turned bullish, which is after a large part of the bull trend is already over. Emotions are the drawback of fundamental analysis. Investors must learn to buy when they are afraid (pessimistic) and sell when they feel euphoric (optimistic). This may sound easy (simple contrary opinion), but without charts it is hard to achieve. The main purpose of technical analysis is to help investors identify turning points which they cannot see because of individual and group psychological factors. Figure 7.1 As a general strategy, it is best to trade with trends, meaning that if the general trend of the market is headed up, you should be very cautious about taking any positions that rely on the trend going in the opposite direction. A trend can also apply to interest rates, yields, equities and any other market which is characterized by a long term movement in price or volume. The Use of Trend One of the most important concepts in technical analysis is that of trend. The meaning of the term "trend" in finance is quite similar to its general definition - "a trend is nothing more than the general direction in which a security or market is headed". Take a look at the chart (Figure 7.2) below: Figure

6 the general direction in which a security or market is headed". Take a look at the chart (Figure 7.2) below: There are lots of ups and downs in the chart above (Figure 7.3) but there is no clear indication of which direction this security is headed. Unfortunately, trends are not always easy to see. In any given chart, you will probably notice that prices do not tend to move in a straight line in any direction. They, however, move in a series of highs and lows. Types of Trends In technical analysis, it is the movement of the highs and lows that constitutes a trend. The following are the 3 types of trends: Uptrend An uptrend is classified as a series of higher highs and higher lows or higher peaks and higher troughs. 6 Figure 7.2 It is not really hard to see that the trend in the chart above is up. However, it's not always this easy to see a trend: Figure 7.4 Figure 7.4 above is an example of an uptrend. Point 2 in the chart is the first high, which is determined after the price falls from this point. Point 3 is the low that is established as the price falls from the high. For this to remain an up-trend each successive low must not fall below the previous lowest point or the trend is deemed a reversal. Figure

7 Downtrend A downtrend is classified as a series of lower lows and lower highs or lower peaks and lower troughs. It describes the price movement of a financial asset when the overall direction is downward. A formal downtrend occurs when each successive peak and trough is lower than the ones found earlier in the trend. Trendlines A trendline can be described as a simple charting technique that adds a line to a chart to represent the trend in the market or a stock. Drawing a trendline is as simple as drawing a straight line that follows a general trend. These lines are used to clearly show the trend and are also used in the identification of trend reversals Figure 7.5 Here, note that each successive peak and trough is lower than the previous one. For example, in Figure 7.5 above, the low at Point 3 is lower than the low at Point 1. The downtrend will be deemed broken once the price closes above the high at Point 4. Sideways/ Horizontal Trend / Consolidation Sideways trend, also known as horizontal trend or consolidation, describes the horizontal price movement that occurs when the forces of supply and demand are nearly equal. A sideways trend is often regarded as a period of consolidation before the price continues in the direction of the previous move. It is classified as a series of horizontal peaks and horizontal troughs. Figure 7.7 As seen in Figure 7.7 above, an upward trendline is drawn at the lows of an upward trend. This line represents the support the stock has every time it moves from a high to a low. Notice how the price is propped up by this support. This type of trendline helps traders to anticipate the point at which a stock's price will begin moving upwards again. Similarly, a downward trendline is drawn at the highs of the downward trend. This line represents the resistance level that a stock faces every time the price moves from a low to a high. Figure 7.6 Sideways / Horizontal Trend / Consolidation Sideways trend, also known as horizontal trend or consolidation, describes the horizontal price movement that occurs when the forces of supply and demand are nearly equal. A sideways trend is often regarded as a period of consolidation before the price continues in the direction of the previous move. It is classified as a series of horizontal peaks and horizontal troughs. The trendline can also said to be nothing more than a straight line drawn between at least three points. In an uptrend, the low points are connected to form an uptrend line (Figure 7.8 below). For a downtrend, the peaks are connected (Figure 7.9 below). The important point is that it should not be drawn over the price action. Trendlines must incorporate all of the price data, i.e. connect the highs in a downtrend and the lows in an uptrend. The closing prices are not connected. The trend line becomes more important and gains credibility as the number of price extremes that can be connected by a single line increases. The validity and viability of a line that connects only two price extremes (for example the starting point and one price low) is questionable

8 Chapter 8 INVESTMENT HORIZONS The trend is broken when the price falls below the uptrend line or rises above the downtrend line (as in Figures 7.8 and 7.9 below). Some analysts use a 2-day rule, which means that the trend is only seen as broken if the price closes above/below the trendline for at least two days. Others use a 1% stop (could be higher depending HOURS Long-term trend (lasts about 12 months) Trendline is broken SECONDS Short-term trend (lasts about 2-6 weeks) 6 5 MINUTES Intermediate-term trend (lasts about 3-6 months) Figure Uptrend Figure 8.1 Investment Horizon A Technician s Perspective Figure Uptrend on market volatility), which means that the trend is only seen as broken if the price closes over 1% above/below the trend line. Trendline is broken Figure Downtrend Time Horizon Fundamental analysis takes a relatively long-term approach in analyzing the market compared to technical analysis. While technical analysis can be used on a timeframe of weeks, days or even minutes, fundamental analysis often looks at data over a number of years. 15 The charts on the previous pages show that investors require a certain perspective. It is imperative to differentiate between a short-term, a medium-term and a long-term trend. If someone asks you to buy the US dollar because it is likely to rise, make sure that you understand whether the dollar is expected to rise over a few days or a few months and if you should buy the dollar with the intention to hold it for several days, several weeks or several months. For a technician on the trading floor, the long-term horizon is entirely different from that of institutional investors. For a trader, long-term can mean several days, while for the investor it can mean 12 to 18 months. We can compare the charts and indicators to a clock (as shown in Figure 8.1 above). Short-term trends (the seconds) are best analyzed on daily bar charts. Medium-term trends (the minutes) are best seen on weekly bar charts and long-term trends (the hours) are best seen on monthly bar charts. Some investors only want to know the hour, some want to know the seconds and some want to know the exact time. However, the best investment results are achieved when all three trends on the daily, weekly and monthly charts point in the same direction. 16

9 SUPPORT AND RESISTANCE Chapter 9 Trend Lengths Apart from the above-mentioned 3 trend directions, there are three trend classifications as well. A trend of any direction can be classified as: Technical analysts often discuss the ongoing battle between the bulls and the bears, or the struggle between buyers (demand) and sellers (supply). This is revealed by the prices a security seldom moves above (resistance) or below (support). Long-term trend In terms of the stock market, a long-term trend is generally categorized as one that lasts for a period longer than a year. Intermediate trend An intermediate trend is considered to last between one and three months and a near-term trend is anything less than a month. A long-term trend is composed of several intermediate trends, which often move against the direction of the major trend. If the major trend is upward and there is a downward correction in price movement followed by a continuation of the uptrend, the correction is considered to be an intermediate trend. Short-term trend The short-term trends are components of both major and intermediate trends. Refer to Figure 8.2 below to get a clear picture of how these three trend lengths might look like. Figure 9.1 As you can see in the Figure 9.1 above, support is the price level below which a stock or market seldom falls (illustrated by the blue arrows). Resistance, on the other hand, is the price level that a stock or market seldom surpasses (illustrated by the red arrows). Resistance lines are horizontal lines that start at a recent extreme price peak with the line pointing horizontally into the future (Figure 9.2). Break of resistance Last peak becomes resistance Last peak becomes resistance Figure 8.2 While analyzing trends, it is very important that the chart is constructed to reflect the type of trend being analyzed in the best possible manner. To help identify long-term trends, weekly charts or daily charts spanning a five-year period are used by chartists to get a better idea of the long-term trend. Daily data charts are best used when analyzing both intermediate and short-term trends. It is also important to remember that the longer the trend, the more important it is; for example, a one-month trend is not as significant as a five-year trend. Last peak becomes resistance Resistance becomes support Figure

10 SUPPORT AND RESISTANCE Support lines are horizontal lines that start at a recent extreme of a correction low and also point towards the future on the time axis (Figure 9.3) 1 2 Support becomes resisitance 3 4 Figure 9.3 An uptrend continues as long as the most recent peak is surpassed and new peak levels are reached. A downtrend continues as long as past lows are broken, sustaining a series of lower lows and lower highs. Notice that the previous support often becomes resistance and resistance becomes support. A resistance or a support line becomes more important and its break gains more credibility as the number of price extremes (peaks for resistance; or lows for support) that can be connected by a single line increases. Last low becomes support Break of support Last low becomes support Last low becomes support Figure 9.4 As you can see in Figure 9.4 above, the dotted line is shown as a level of resistance that has prevented the price from heading higher on two previous occasions (Points 1 and 2). However, once the resistance is broken, it becomes a level of support (shown by Points 3 and 4) by propping up the price and preventing it from heading lower again. Many traders who begin using technical analysis find this concept hard to believe and do not realize that this phenomenon occurs rather frequently, even with some of the most well-known companies. For example, as you can see in Figure 9.5 below, this phenomenon is evident on the Wal-Mart Stores Inc. (WMT) chart between 2003 and Notice how the role of the $51 level changes from a strong level of support to a level of resistance. Why does it happen? The support and resistance levels are considered important in terms of market psychology and supply and demand. Support and resistance levels are the levels at which a lot of traders are willing to buy the stock (in case of a support) or sell it (in case of resistance). When these trendlines are broken, the supply and demand and the psychology behind the stock's movements is considered to have shifted, in which case new levels of support and resistance are likely to be established. Role Reversal Once a resistance or a support level is broken, its role is reversed. If the price falls below a support level, that level will become resistance. If the price rises above a resistance level, it will often become support. As the price moves past a level of support or resistance, it is considered that supply and demand have shifted, causing the breached level to reverse its role. For a true reversal to occur, however, it is important that the prices make a strong move through either the support or resistance. Figure 9.5 In almost every case, a stock will have both a level of support and a level of resistance and will trade in this range as it bounces between these levels. This is most often seen when a stock is trading in a generally sideways manner as the price moves through successive peaks and troughs, testing resistance and support

11 Chapter 10 VOLUME - THE NEGLECTED ESSENTIA Importance of Support and Resistance While price is the primary item of concern in technical analysis, volume is also extremely important. Support and resistance analysis is an important part of trends because it can be used to make trading decisions and identify when a trend is reversing. For example, if a trader identifies an important level of resistance that has been tested several times but never broken, he or she may decide to take profits as the security moves towards this point because it is unlikely that it will move past this level. Support and resistance levels both test and confirm trends and need to be monitored by anyone who uses technical analysis. As long as the price of a share remains between these levels of support and resistance, the trend is likely to continue. It is important to note, however, that a break beyond a level of support or resistance does not always have to be a reversal. For example, if prices move above the resistance levels of an upward trending channel, the trend has accelerated, not reversed. This means that the price appreciation is expected to be faster than it was in the channel. What is volume? Volume refers to the number of shares or contracts that trade over a given period of time, usually a day. The higher the volume, the more active the security. To determine the movement of the volume (up or down), chartists look at the volume bars that can usually be found at the bottom of any chart. Volume bars illustrate how many shares have traded per period and show trends in the same way that prices do (Figure 10.1). Being aware of these important support and resistance points should affect the way that you trade a stock. Traders should avoid placing orders at these major points, as the area around them is usually marked by a lot of volatility. If you feel confident about making a trade near a support or resistance level, it is important that you follow this simple rule: do not place orders directly at the support or resistance level. This is because in many cases, the price never actually reaches the whole number, but flirts with it instead. So if you're bullish on a stock that is moving toward an important support level, do not place the trade at the support level. Instead, place it above the support level, but within a few points. On the other hand, if you are placing stops or short selling, set up your trade price at or below the level of support. Figure 9.1 Importance of Volume Volume is an important aspect of technical analysis because it is used to confirm trends and chart patterns. Any price movement up or down with relatively high volume is seen as a stronger, more relevant move than a similar move with weak volume. Therefore, if you are looking at a large price movement, you should also examine the volume to see whether it tells the same story

12 Say, for example, a stock jumps 5% in one trading day after being in a long downtrend. Is this a sign of a trend reversal? This is where volume helps traders. If volume is high during the day relative to the average daily volume, it is a sign that the reversal is probably for real. On the other hand, if the volume is below average, there may not be enough conviction to support a true trend reversal. Volume should move with the trend. If prices are moving in an upward trend, volume should increase (and vice versa). If the previous relationship between volume and price movements starts to deteriorate, it is usually a sign of weakness in the trend. For example, if the stock is in an uptrend but the up trading days are marked with lower volume, it is a sign that the trend is starting to lose its legs and may soon end. When volume tells a different story, it is a case of divergence, which refers to a contradiction between two different indicators. The simplest example of divergence is a clear upward trend on declining volume. Volume and Chart Patterns The other use of volume is to confirm chart patterns. Patterns such as head and shoulders, triangles, flags, and other price patterns can be confirmed with volume. In most chart patterns, there are several pivotal points that are vital to what the chart is able to convey to chartists. Basically, if the volume is not there to confirm the pivotal moments of a chart pattern, the quality of the signal formed by the pattern is weakened. Volume precedes price Stock market shares are traded for as long as a company stays in the business as a separate unit. On the other hand, futures and options traders deal in contracts for a future delivery that expires at a pre-defined time. A futures or options buyer who wants to accept a delivery and a seller who wants to deliver, have to wait until the first notice day. This waiting period ensures that the numbers of contracts that are long and short are always equal. However, very few futures and options traders plan to deliver or to accept delivery. They usually close out their positions before the first notice day. Open interest rises or falls depending upon whether new traders enter the market or old traders exit it. In this context, the following points must be noted: 1. It rises only when a new buyer and a new seller enter the market, thereby creating a new contract. 2. It falls when a trader who is long, trades with someone who is short. When both of them close out their positions, open interest falls by one contract because one contract disappears. 3. If a new bull buys from an old bull that is getting out of his position, open interest remains unchanged. 4. Open interest also does not change when a new bear sells to an old bear who needs to buy because he is closing out his short position. The following table will serve as a ready reckoner for the above: Another important idea in technical analysis is that price is preceded by volume. Volume is closely monitored by technicians and chartists to form ideas on upcoming trend reversals. If volume starts decreasing in an uptrend, it is usually a sign that the upward run is about to end. Now that we have a better understanding of some of the important factors of technical analysis, we can move on to charts, which help to identify trading opportunities in price movements. Buyer Seller Open Interest New Buyer New seller Increases New buyer Former buyer sells Unchanged Former seller buys to cover New seller Unchanged Former seller buys to cover Former buyer sells Decrease Open Interest Open Interest is the number of contracts that are held by buyers or are owned by short sellers in a given market on a given day. It shows the number of existing contracts. Open interest equals either a total long or a total short position. Open Interest is also said to be the total number of options and/or futures contracts that are not closed or delivered on a particular day. Open interest applies primarily to the futures market. Technicians usually plot open interest as a line below the price bars (Figure 10.2 below). Some chart services also plot average open interest for the past several years. Open interest gives important messages when it deviates from its seasonal norm. It varies from season to season in many markets because of huge hedging by commercial interests at various stages in production cycles

13 Chapter 11 CHART What is a chart? In technical analysis, charts are similar to the charts that you see in any business setting. A chart is simply a graphical representation of a series of prices over a set time frame. It helps to identify trading opportunities in prices movements. For example, a chart may show a stock's price movement over a one-year period, where each point on the graph represents the closing price for each day the stock is traded. Figure 10.2 Open Interest As already discussed, open interest (01) reflects the number of all short and long positions in any futures or options market. It depends on the intensity of conflict between bulls and bears. The findings of the above can be enumerated as under: 1. Rising 01 indicates that the conflict between bulls and bears is becoming more intense and confirms the existing trend. 2. Rising OI during uptrends show that it is safe to add to long positions (A and D). 3. Flat 01 shows that fewer losers are entering the market. This means that a mature trend is nearing its end and it is time to take profits or tighten stops (8 and E). 4. Falling 01 shows that losers are leaving the market and winners are cashing in - that a trend is nearing its end. 5. As a fire cannot continue when fuel is withdrawn, a sharp drop in 01during a trend signals the nearing of a reversal (C and F). 6. At the right edge of the chart, cocoa prices have stabilized after falling in October and 01 is flat. It shows that the decline in cocoa has shaken out weak bulls and the uptrend is ready to resume. It is time to go long, with a protective stop below the recent lows. Figure 11.1 Figure11.1 above is an illustration of a basic chart. It is a representation of the price movements of a stock over a one and a half year period. The bottom of the graph, running horizontally (x-axis) is the date or time scale. On the right hand side, running vertically (y-axis), is the price of the security. By looking at the graph, we cannot ice that in October 2004 (Point # 1), the price of this stock was around $245, whereas in June 2005 (Point# 2), the stock's price was around $265. This tells us that the stock has risen between October 2004 andjune2005. Properties of Charts The following are some of the properties of charts that one should be aware of when looking at a chart, as these factors can affect the information that is provided: 25 26

14 The Time Scale The time scale refers to the range of dates at the bottom of the chart, which can vary from decades to seconds. The most frequently used time scales are intraday, daily, weekly, monthly, quarterly and annually. It should be noted that the shorter the time frame, the more detailed the chart. Each data point can represent the closing price of the period or show the open, the high, the low and the close depending on the chart used. Intraday charts plot price movements within the period of one day. This means that the time scale could be as short as five minutes or could cover the whole trading day from the opening bell to the closing bell. Daily charts are comprised of a series of price movements in which each price point on the chart is a full day's trading condensed into one point. Again, each point on the graph can be simply the closing price or can entail the open, high, low and close for the stock over the day. These data points are spread out over weekly, monthly and even yearly time scales to monitor both short-term and intermediate trends in price movement. Weekly, monthly, quarterly and yearly charts are used to analyze long term trends in the movement of a stock's price. Each data point in these graphs will be a condensed version of what happened over the specified period. So for a weekly chart, each data point will be a representation of the price movement of the week. Figure 11.2 Now refer to the Figure 11.3 below. If a price scale is in logarithmic scale, then the distance between points will be equal in terms of percent change. A price change from 10 to 20 is a 100% increase in the price, while a move from 40 to 50 is only a 25% change, even though they are represented by the same distance on a linear scale. On a logarithmic scale, the distance of the 100% price change from 10 to 20 will not be the same as the 25% change from 40 to 50. In this case, the move from 10 to 20 is represented by a larger space on the chart while the move from 40 to 50, is represented by a smaller space because, percentage-wise, it indicates a smaller move. In Figure 11.2, the logarithmic price scale on the right leaves the same amount of space between 10 and 20 as it does between 20 and 30 because both represent 100% increase. Price Scale and Price Point The price scale is on the right-hand side of the chart. It shows a stock's current price and compares it to past data points. This may seem like a simple concept in that the price scale goes from lower prices to higher prices as you move along the scale from the bottom to the top. The problem, however, is in the structure of the scale itself. A scale can either be constructed in a linear (arithmetic) or logarithmic way, and both of these options are available on most charting services. Refer to the Figure 11.2 below. If a price scale is constructed using a linear scale, the space between each price point (10, 20, 30, 40) is separated by an equal amount. A price move from 10 to 20 on a linear scale is the same distance on the chart as a move from 40 to 50. In other words, the price scale measures moves in absolute terms and does not show the effects of percent change. Figure

15 Types of Charts There are four main types of charts that are used by investors and traders depending on the information that they are seeking to derive and their individual skill levels. The chart types are: the line chart, the bar chart, the candlestick chart and the point and figure chart. In the following section, we will focus on the S&P 500 Index during the period of January 2006 through May Notice how the data used to create the charts is the same, but the way the data is plotted and shown in the charts is different. is lower than the right dash (close) then the bar will be shaded black, representing an up period for the stock, which means that it has gained value. A bar that is coloured red signals that the stock has gone down in value over that period. When this is the case, the dash on the right (close) is lower than the dash on the left (open) Line Charts The most basic of the four charts is the line chart because it represents only the closing prices over a set period of time. The line is formed by connecting the closing prices over the time frame. Line charts do not provide visual information of the trading range for the individual points such as the high, low and opening prices. However, the closing price is often considered to be the most important price in stock data compared to the high and low for the day and this is why it is the only value used in line charts. Candlestick Charts Figure 11.5 Bar Charts The candlestick chart is similar to a bar chart, but it differs in the way that it is visually constructed. Similar to the bar chart, the candlestick also has a thin vertical line showing the period's trading range. The difference comes in the formation of a wide bar on the vertical line, which illustrates the difference between the open and close. Figure 11.4 Line Chart Bar Charts The bar chart expands on the line chart by adding several more key pieces of information to each data point. The chart is made up of a series of vertical lines that represent each data point. This vertical line represents the high and low for the trading period, along with the closing price. The close and open are represented on the vertical line by a horizontal dash. The opening price on a bar chart is illustrated by the dash that is located on the left side of the vertical bar. Conversely, the close is represented by the dash on the right. Generally, if the left dash (open) Figure 11.6 Candlestick Charts 29 30

16 JAPANESE CANDLESTICK PATIERNS Chapter 12 Point and Figure Charts The point and figure chart is not very popular, nor is it widely used by the average investor, but it has had a long history of use dating back to the first technical traders. This type of chart reflects price movements and is not as concerned about time and volume in the formulation of the points. The point and figure chart removes the noise, or insignificant price movements, in the stock, which can distort the traders' view of the price trends. These types of charts also try to neutralize the skewing effect that time has on chart analysis. Candlesticks contain the same data as a normal bar chart but highlight the relationship between opening and closing prices. In a candlestick, the narrow stick represents the range of prices traded during the period (high to low) while the broad mid-section represents the opening and closing prices for the period (Figure 12.1 below). If the close is higher than the open the candlesticks mid-section is hollow or shaded blue/green. If the open is higher than the close the candlestick mid-section is filled in or shaded red. Candlesticks Highest Price Closing Price Highest Price Opening Price Opening Price Closing Price Lowest Price Lowest Price The body is filled if the open is higher then the close Figure 12.1 Candlestick Patterns Figure 11.7 Point & Figure Charts The advantage of candlesticks is the ability to highlight trend weakness and reversal signals that may not be apparent on a normal bar chart. Since most of the candlestick indicators are reversals in nature, we must emphasise on the subject of reversal patterns. The following are some of the important groups of these candlestick reversal indicators: Charts are one of the most fundamental aspects of technical analysis. It is important that you clearly understand what is being shown on a chart and the information that it provides. Reversal Patterns Hammer Lines This pattern is a price pattern in candlestick charting that occurs when a security trades significantly lower than its opening, but rallies later in the day to close either above or close to its opening price. This pattern forms a hammer-shaped candlestick

17 the highest price for the day the highest price for the day Opening Price Closing Price Body is black (or red) if stock closed lower, Body is white (or green) if it closed higher smaller body closing price opening price the lowest price for the day the lowest price for the day Figure 12.2 Candlestick Reversal Pattern: Hammer Lines Figure 12.4 Candle Reversal Pattern: Engulfing Pattern Bullish A hammer occurs after a security has been declining, possibly suggesting that the market is attempting to determine a bottom. However, it does not mean that the bullish investors have taken full control of a security; it simply indicates that the bulls are strengthening. Hanging-man Lines This pattern is a bearish candlestick pattern that forms at the end of an uptrend. It is created when there is a significant selloff near the market open price, but buyers are able to push this stock back up so that it closes at or near the opening price. Generally the large sell-off is seen as an early indication that the bulls (buyers) are losing control and demand for the asset is This trend suggests that the bulls have taken control of a security's price movement from the bears. This type of pattern usually accompanies a declining trend in a security, suggesting that a low or end to a security's decline has occurred. However, as usual in candlestick analysis, the trader must take the preceding and the following days' prices into account before making any decisions regarding the security. Engulfing Pattern Bearish A chart pattern that consists of a small white candlestick with short shadows or tails followed by a large black candlestick that eclipses or "engulfs" the small white one. waning smaller body the highest price for the day closing price opening price the lowest price for the day Figure 12.3 Candlestick Reversal Pattern: Hanging-man Line Figure 12.5 Candlestick reversal Pattern: Engulfing Pattern Bearish Engulfing Pattern Bullish This chart pattern forms when a large white candlestick that completely eclipses or "engulfs" the previous day's candlestick follows a small black candlestick. The shadows or tails of the small candlestick are short, which enables the body of the large candlestick to cover the entire candlestick from the previous day. A bearish engulfing pattern may provide an indication of a future bearish trend. This type of pattern usually accompanies an uptrend in a security, possibly signaling a peak or slowdown in its advancement. However, whenever a trader analyzes any candlestick pattern, before making any decisions, it is important for him or her to consider the prices of the days that precede and follow the formation of the pattern

18 Dark Cloud Cover In candlestick charting, Dark Cloud Cover is a pattern where a black candlestick follows a long white candlestick. It can be an indication of a future bearish trend. Stars Another group of fascinating reversal patterns is that which includes stars. A Star is a small real body that gaps away from the large real body preceding it. It is a warning that the prior trend may be ending. The star is a part of 4 reversal patterns that include the following: the highest price for the day Closing price Large white candlestick opening price opening price confirmation i. The Morning Star This is a bullish candlestick pattern that consists of 3 candles that have demonstrated the following characteristics: the lowest price for the day Figure 12.6 Candlestick Reversal Patterns: Dark Cloud Cover Essentially, the large black candle is forming a "dark cloud" over the preceding bullish trend. The dark cloud must have a closing price that is : 1. Within the price range of the previous day, but 2. Below the mid-point between open and closing prices of the previous day. Piercing Pattern This refers to a day's trading activity that often signals the end of a small to moderate downward trend. Following a closing down day with a good-sized trading range, the next day's trading gap (drops) lowers, but also covers at least half of the upward length of the previous day's real body (the range between the opening and closing prices), and then closes up for the day. A piercing pattern can serve as an indicator that it is time to either buy a stock or close out short positions, because he stock may be trending upwards soon. It should not, however, be used as a stand-alone indicator, but rather compared against other bullish and bearish indicators. The first bar is a large red candlestick located within a defined downtend The second bar is a small-bodied candle (either red or white) that closes below the first red bar. The last bar is a large white candle that opens above the middle candle and closes near the center of the first bar's body. As shown by the chart below (Figure 12.8), this pattern is used by traders as an early indication that the downtrend is about to reverse. Strong black body Closing at least halfway the prior body Lower opening price Figure 12.7 Candlestick Reversal Pattern: Piercing Pattern Figure 12.8 The Morning Star A morning star pattern can be useful in determining trend changes, particularly when used in conjunction with other technical indicators. Many traders also use price oscillators such as the MACD (Moving Average Convergence Divergence) and RSI (Relative Strength Index), explained later in this tutorial, to confirm the reversal

19 ii. The Evening Star Stars This is a bearish candlestick pattern consisting of three candles that have demonstrated the following characteristics: bar's body. The first bar is large white candlestick located within an uptrend. The middle bar is a small-bodied candle (red-white) that closes above the first white bar. The last bar is a large red candle that opens below the middle candle and closes near the center of the first Another group of fascinating reversal patterns is that which includes stars. A Star is a small real body that gaps away from the large real body preceding it. It is a warning that the prior trend may be ending. The star is a part of 4 reversal patterns that include the following: i. The Morning Star This is a bullish candlestick pattern that consists of 3 candles that have demonstrated the following characteristics: As shown by the chart below (Figure 12.9), this pattern is used by traders as an early indication that the uptrend is about to reverse. The first bar is a large red candlestick located within a defined downtend The second bar is a small-bodied candle (either red or white) that closes below the first red bar. The last bar is a large white candle that opens above the middle candle and closes near the center of the first bar's body. Figure 12.9 The Evening Star As shown by the chart below (Figure 12.8), this pattern is used by traders as an early indication that the downtrend is about to reverse. Evening star formations can be useful in determining trend changes, particularly when used in conjunction with other indicators. Many traders use price oscillators and trend lines to confirm this candlestick pattern. iii. The Morning and Evening Doji Stars A doji is a candle that lacks a real body, meaning the open and close of the bar are the same or have a very small difference. It has a strong significance after substantial advances or declines. The lack of direction that the doji illustrates can offer a potent reversal signal, especially if it is followed by a candle in the anticipated direction. Therefore, when a doji represents the star of the morning and evening star pattern, you need to take notice. When a doji represents the morning star and evening star, the formations are known as the morning doji star and evening doji star

20 Figure The Evening Doji Star and The Morning Star. An extremely powerful version of the doji star is known as the abandoned baby top or abandoned baby bottom. This pattern is equivalent to what we heard of through using bar charts, the island reversal. The abandoned baby candlestick has a doji as the second candle with a gap on both sides. In order for a candlestick to be considered a shooting star, the formation must be on an upward or bullish trend. Furthermore, the distance between the highest price for the day and the opening price must be more than twice as large as the shooting star's body. Finally, the distance between the lowest price for the day and the closing price must be very small or non-existent. A shooting star shaped candlestick, after a downturn, could be a bullish signal. Such a line is called an Inverted Hammer. Figure below illustrates that an inverted hammer looks like a shooting star line with its long upper shadow and small real body at the lower end of the range. However, while the shooting star is a top reversal line, the inverted hammer is a bottom reversal line. As with a regular hammer, the inverted hammer is a bullish pattern after a downtrend. Abandoned Baby Gap Gap Gap Gap Abandoned Baby Figure The Abandoned Baby Top and The Abandoned Baby Bottom Figure Inverted Hammer The Inverted Hammer pattern is a two candle, bottom reversal pattern, but requires a third candle for confirmation, because of the way the pattern is formed. iv. Shooting Star and The Inverted Hammer More Reversal Patterns A type of candlestick formation that results when a security's price, at some point during the day, advances well above the opening price but closes lower than the opening price. the highest price for the day The reversal formations discussed above, namely, reversal patterns and stars, are comparatively strong reversal signals. They show that the bulls have taken over from the bears (as in the bullish engulfing pattern, a morning star, or a piercing pattern) or that the bears have wrested control from the bulls (as in the bearish engulfing pattern, the evening star, or the dark-cloud cover). We shall now discuss more reversal indicators which are usually, but not always, less powerful reversal signals. Harami Pattern open price closing price the lowost price for the day The harami pattern (see Figure below) is a small real body which is contained within a prior relatively long real body. 'Harami' is an old Japanese term which means 'pregnant'. The long candlestick is 'the mother' candlestick and the small candlestick is the 'baby' or 'foetus'. The harami pattern is the reverse of the engulfing pattern. In the engulfing pattern, a lengthy Figure Shooting Star 39 40

21 real body engulfs the preceding small real body. For the harami, a small real body follows an unusually long real body. i. Bearish Harami Pattern This is a candlestick pattern which is indicated by a large candlestick followed by a much smaller candlestick where in that body is located within the vertical range of the larger candle's body. Such a pattern is an indication that the previous upward trend is coming to an end. i. Bullish Harami Pattern Figure The Harami Pattern the highest price for the day Closing price body is black (or red) if stock closed lower. Body is white (or green) if it closed higher opening price smaller body This is a candlestick chart pattern in which a large candlestick is followed by a smaller candlestick whose body is located within the vertical range of the larger body. In terms of candlestick colors, the bullish harami is a downtrend of negative-colored (black) candlesticks engulfing a small positive (white) candlestick, giving a sign of a reversal of the downward trend. the lowest price for the day Figure Bearish Harami Pattern A bearish harami may be formed from a combination of a large white or black candlestick and a smaller white or black candlestick. The smaller the second and lestick, the more likely the reversal. When a large white candle stick is followed by a small black candlestick, it is thought to be a strong sign of a trend ending. Harami Cross the highest price for the day opening price body is black (or red) if stock closed lower. Body is white (or green) if it closed higher closing price the lowest price for the day smaller body This candlestick pattern is indicated by a large candlestick followed by a doji that is located within the top and bottom of the candlestick's body. This indicates that the previous trend is about to reverse. the highest price for the day closing price body is black (or red) if stock closed lower. Body is white (or green) if it closed higher opening price the lowest price for the day Bearish Harami Cross Doji (cross) Figure Bullish Harami Pattern Because the bullish harami indicates that the falling trend (bearish trend) may be reversing, it signals that it is a good time to enter into a long position. The smaller the second (white) candlestick, the more likely the reversal. Bearish Harami Cross the highest price for the day opening price body is black (or red) if stock closed lower. Body is white (or green) if it closed higher closing price the lowest price for the day Doji (cross) Figure Harami Cross Bearish & Bullish 41 42

22 A Harami cross can be either bullish or bearish, depending on the previous trend (Figure above). The appearance of a Harami Cross, rather than a smaller body, increases the likelihood that the trend will reverse. Tweezer Tops and Bottoms The Candlestick theory recognizes both a tweezer top and a tweezer bottom. The tweezers formation always involves two candles. At a tweezer top, the high price of two nearby sessions is identical. Meanwhile, at a tweezer bottom, the low price of two sessions that come in close succession is the same. Windows A window is a gap between the prior and the current session's price extremes. It can be said to be a break between prices on a chart that occurs when the price of a stock makes a sharp move up or down with no trading occurring in between. Such windows, also referred to as gaps, can be created by factors such as regular buying or selling pressure, earnings announcements, a change in an analyst's outlook or any other type of news release. In some instances, the tweezer bottom is formed by two real candlestick bodies that make an identical low. In other instances, the lower shadows of two nearby candles touch the same price level and the stock then bounces higher. Meanwhile, a third possibility is that the lower shadow of one day and the real body of a nearby session hit the same bottom level. Tweezers can also be defined as a pattern found in technical analysis of options trading. Tweezer patterns occur when two or more candlesticks touch the same bottom for a tweezer bottom pattern or top for a tweezer top pattern. This type of pattern can be made with candlestick charts of various types. Figure Windows or Gaps An example of two different gaps can be seen in the chart above (Figure 12.20). Notice how the stock closes the trading session before the first gap at $50 and opens the next trading day near $46 with no trading occurring between the two prices. Gaps are a regular occurrence in all financial markets. However, they are rarely seen in the forex market since it is highly liquid and trades 24 hours a day. Figure Tweezer Top Patterns Figure below shows an open window that forms in an uptrend. There is a gap between the prior upper shadow and this session's lower shadow. Tweezer bottoms are considered to be short-term bullish reversal patterns. Tops are bearish, and either end means that buyers or sellers were not able to push the top or bottom any further. Both types of patterns require close observation and research in order to be interpreted and used correctly. Continuation Pattern Window Closed Window But No Selling Follow Through Most candlestick signals are trend reversals. However, there are a group of candlestick patterns which are continuation indicators. As the Japanese express it, "there are times to buy, times to sell, and times to rest." Many of these patterns imply a time of rest, a breather, before the market resumes its prior trend. Figure Window in an uptrend 43 44

23 Figure below shows a window in a downtrend. It shows no price activity between the previous day's lower shadow and the current day's upper shadow. Downward Tasuki Gap The Downside Tasuki Gap is a three day candlestick continuation pattern. The pattern starts with a red candlestick that has gapped below the previous red candlestick. The third and final candlestick is a green candlestick that opens inside the body of the second red candlestick. Traders should go short on the close of the third candlestick. They should trade in the direction of the Downside Tasuki Gap, which is a defined up downtrend. Window Gap Downside Upward/ Upside Tasuki Gap Figure Window in a downtrend The Upside Tasuki Gap is a three day candlestick continuation pattern. The pattern starts with a green candlestick that has gapped above the previous green candlestick. The third and final candlestick is a red candlestick that opens inside the body of the second green candlestick. Traders should go long on the close of the third candlestick. Traders should trade in the direction of the Upside Tasuki Gap, which is a defined up trend. High-price and Low-price Gapping Plays Figure Downward Tasuki Gap After a sharp one to two session advance, it is normal for the market to consolidate the gains. Sometimes this consolidation is by a series of small real bodies. A group of small real bodies after a strong session tells us that the market is undecided. However, if there is an upside gap on the opening (a window) from these small real bodies, it is time to buy. This is high-price gapping play pattern (Figure below), so called because prices hover near their recent highs and then gaps to the upside. Window Gap up Figure Upward Tasuki Gap Figure High-price Gapping Play 45 46

24 Contrary to the general belief, a low-price gapping play is not the bearish counterpart of the high-price gapping play. The lowprice gapping play (Figure below) is a downside window from a low-price congestion band. This congestion band (a series of small real bodies) initially stabilized a steep one to two session decline. At first, this group of small candlesticks gives the appearance that a base is forming. The break to the downside via a window dashes these bullish hopes. Window Figure Gapping Side-by-side White Lines in a Downtrend Window Rising and Falling Three Methods These three methods include the bullish rising three methods and the bearish falling three methods. These are both continuous patterns. Gapping Side-by-side White Lines Figure Low price Gapping Play In an uptrend, an upward-gapping white candlestick follows the next session by another similar sized white candlestick with about the same opening is a bullish continuation pattern. This two candlestick pattern is referred to as upgap side-by-side white lines (Figure below). If the market closes above the higher of the side-by-side white candlesticks, another leg up should unfold. i. Bullish Rising Three Methods Pattern The Rising Three Methods is a candlestick continuation pattern which indicates the continuation of a bullish trend even after a temporary halt in trading. It is a multiple candlestick pattern which includes more than three candlesticks (ideally include five candlesticks) of which the first and last candlesticks are long bullish (white/colorless) candlesticks. The middle candlesticks may be all bearish (black/colored) or can be a mixture of bullish and bearish candlesticks. Bullish rising three methods is highly reliable when all middle candlesticks are bearish. Bullish Rising Three Methods Window Figure Gapping Side-by-side White Lines in an uptrend The side-by-side white candlesticks described previously are rare. Even more rare are side-by-side white lines which gap lower. These are called downgap side-by-side white lines (Figure below). In a downtrend, the side-by-side white lines are also a continuation pattern. That is, prices should continue to lower. The reason this pattern is not bullish (as is the upgap variety) is because in a falling market, these white lines are viewed as short covering. Figure Bullish Rising Three Methods Pattern This pattern occurs when bears are unable to bring the prices down below first day's range. This boosts the confidence of the bulls and the prices are then taken to the new highs

25 This pattern is considered to be a highly reliable trend continuation pattern. Reliability of the pattern increases with shortening of real-bodies (doji formations) of middle candlesticks and decrease in trading volumes on middle days. Confirmation is still suggested with this formation which can be a bullish candlestick on new day. i. Bearish Falling Three Methods Pattern The Falling Three Methods is a candlestick pattern which indicates bearish market continuation even after a temporary halt in trend. This is a multiple candlestick pattern which includes more than three candlesticks, of wt1ich,the first and the last will be long bearish candlesticks. The middle candlesticks can be all white (bullish or colorless) or a mix of white and black (bearish or colored) candlesticks. Reliability is the highest when all middle candlesticks are bullish. Long-legged Doji A long-legged doji is a far more dramatic candle. It signifies that prices moved far higher on the day, but that profit taking has kicked in. Typically, it leaves a very large upper shadow. A close below the midpoint of the candle shows a lot of weakness. Doji Figure Common Doji / Doji Long - Legged Doji Falling Three Methods Gravestone Doji Figure Long legged Doji A gravestone doji, as the name implies, is probably the most ominous candle of all. On the day this candle is formed, prices rally, but cannot stand the 'altitude' they achieved. By the end of the day, they come back and close at the opening level. Gravestone Doji Figure Bearish Falling Three Methods Pattern This formation occurs when the bulls are unable to bring the price to new highs after a significant downtrend. It boosts the confidence of bears and prices are then taken to new lows. This is a highly reliable pattern of trend continuation. Reliability increases with shortening of real-body of middle candlesticks and reduction in trading volume on middle days. Confirmation of trend-continuation is still suggested which can be a new candlestick with lower closing. The Magic Doji A doji is a candlestick in which the opening and closing prices are the same. If prices close very close to the same level (so that no real body is visible), then that candle is read as a doji. A doji candlestick looks like a cross, inverted cross, or plus sign. Alone, doji are neutral patterns. There are four types of dojis: Common Doji A Common Doji has a relatively small trading range. It reflects indecision in some manner. Dragonfly Doji Figure Gravestone Doji A dragonfly doji depicts a day on which prices opened at a high, sold off, and then returned to the opening price. Dragonflies are fairly unusual. However, when they do occur, they often resole bullishly (provided the stock is not already overbought). Dragonfly Doji Figure _ Dragobfly Doji The philosophy is that a doji can be a significant warning and that it is better to attend to a false warning than to ignore a real one. To ignore a doji, with all its inherent implications, could be dangerous

26 Chapter 13 CHART PATTERNS What are Chart Patterns? A chart pattern is a distinct formation on a stock chart that creates a trading signal, or a sign of future price movements. Chartists use these patterns to identify current trends and trend reversals and to trigger buy and sell signals. The theory behind chart patterns is based on the assumption that "history repeats itself", as discussed earlier. The idea here is that certain patterns are seen many times, and that these patterns signal a certain high probability move in a stock. Based on such historic trend of a chart pattern setting up a certain price movement, chartists look for these patterns to identify trading opportunities. While there are general ideas and components related to every chart pattern, there is no chart pattern that will tell you with 100% certainty where a security is headed. This creates some leeway and debate as to what a good pattern looks like, and is a major reason why charting is often seen as more of an art than a science. Types of Chart Patterns Figure 13.2 Head and Shoulders Bottom or Inverse Head and Shoulders ii. Double Tops and Bottoms - This chart pattern is another well-known pattern that signals a trend reversal - it is considered to be one of the most reliable patterns and is commonly used. These patterns are formed after a sustained trend and signal to chartists that the trend is about to reverse. The pattern is created when a price movement tests support or resistance levels twice and is unable to break through. This pattern is often used to signal intermediate and long-term trend reversals. Essentially, there are 2 types of patterns within this area of technical analysis. These patterns can be found over charts of any timeframe: Reversal Patterns A reversal pattern signals that a prior trend will reverse upon the completion of the pattern. i. Head and Shoulder This is one of the most popular and reliable chart patterns in technical analysis. Head and shoulders is reversal chart pattern that when formed, signals that the security is likely to move against the previous trend. Figure 13.3 Double Top Pattern Figure 13.4 Double Bottom Pattern Figure Head and shoulders Top Pattern 51 52

27 iii. Triple Tops and Bottoms - These are another type of reversal chart pattern in chart analysis. These are not as prevalent in charts as head and shoulders and double tops and bottoms, but they act in a similar fashion. These two chart patterns are formed when the price movement tests a level of support or resistance three times and is unable to break through; this signals a reversal of the prior trend. Continuation Patterns A continuation pattern signals that a trend will continue once the pattern is complete. i. Cup and Handle - A cup and handle chart is a bullish continuation pattern in which the upward trend has paused but will continue in an upward direction once the pattern is confirmed. Figure 13.8 Cup and Handle Pattern Figure 13.6 Triple Bottom Pattern ii. Triangles - Triangles are one of the most well-known chart patterns used in technical analysis. The three types of triangles, which vary in construct and implications, are symmetrical triangle, ascending triangle and descending triangle. These chart patterns are considered to last anywhere from a couple of weeks to several months. iv. Rounding Bottom - A rounding bottom, also referred to as a saucer bottom, is a long-term reversal pattern that signals a shift from a downward trend to an upward trend. This pattern is traditionally thought to last anywhere from several months to several years. Figure 13.9 Symmetrical Triangle Pattern Figure 13.7 Rounding Bottom Pattern 53 54

28 Figure Ascending Triangle Pattern Other Patterns Figure Ascending Triangle Pattern i. Wedge - The wedge chart pattern can be either a continuation or reversal pattern. It is similar to a symmetrical triangle except that the wedge pattern slants in an upward or downward direction, while the symmetrical triangle generally shows a sideways movement. The other difference is that wedges tend to form over longer periods, usually between three and six months. The fact that wedges are classified as both continuation and reversal patterns can make reading signals confusing. However, at the most basic level, a falling wedge is bullish and a rising wedge is bearish. Figure Descending Triangle Pattern iii. Flag and Pennant - These two short-term chart patterns are continuation patterns that are formed when there is a sharp price movement followed by a generally sideways price movement. This pattern is then completed upon another sharp price movement in the same direction as the move that started the trend. The patterns are generally thought to last from one to three weeks. Figure Wedge Pattern ii. Gaps - A gap in a chart is an empty space between a trading period and the following trading period. This occurs when there is a large difference in prices between two sequential trading periods. Gap price movements can be found on bar charts and candlestick charts but will not be found on point and figure or basic line charts. Gaps generally indicate that some event of significance has occurred in relation to a security, such as a better than- expected earnings announcement. Figure Descending Triangle Pattern 55 56

29 Chapter 14 There are three main types of gaps - breakaway, runaway (measuring) and exhaustion. A breakaway gap forms at the start of a trend, a runaway gap forms during the middle of a trend and an exhaustion gap forms near the end of a trend. iii. Channels - A channel, or channel lines, can be described as the addition of two parallel trendlines that act as strong areas of support and resistance. The upper trendline connects a series of highs, while the lower trend line connects a series of lows. A channel can slope upward, downward or sideways. However, regardless of the direction, the interpretation still remains the same. Traders will expect a given security to trade between the two levels of support and resistance until it breaks beyond one of the levels. In this case, traders can expect a sharp move in the direction of the break. Along with clearly displaying the trend, channels are mainly used to illustrate important areas of support and resistance. Day Close 5-day Total 5-day Average x x x x x x x x Day Close 5-day Total 5-day Average Figure 14.1 What are Moving Averages? Figure Ascending Triangle Pattern Figure above illustrates a descending channel on a stock chart; the upper trendline has been placed on the highs and the lower trend line is on the lows. The price has bounced off these lines several times, and has remained range-bound for several months. As long as the price does not fall below the lower line or move beyond the upper resistance, the range-bound downtrend is expected to continue. It is important to be able to understand and identify trends so that you can trade with them, and not against them. The following are the two important sayings in technical analysis that illustrate how important trend analysis is for technical traders: 1. Trend is your friend 2. Dont t buck the trend Chart patterns usually show a lot of variation in price movement. This can make it difficult for traders to get an idea of a security's overall trend. One simple method traders use to combat this is to apply moving averages. A moving average is the average price of a security over a set period of time. By plotting a security's average price, the price movement is smoothed out. Once the day-to-day fluctuations are removed, traders are better able to identify the true trend and increase the probability that it will work in their favour. Example: For a 5-day moving average you simply add the closing prices of the last five closings and divide this sum by 5. You add each new closing price and skip the oldest. Thus, the number of closing prices considered always remains constant at 5 days (Figure 14.2)

30 Figure 14.2 Price and 5-day Moving Average However, whether you choose a 1O-day average or a 40-week average, the calculation is the same; instead of adding 5 days, you add the closing prices of 10 days or 40 weeks and divide the sum by 10 or 40 respectively. Figure 14.3 Simple Moving Average Functions of Moving Averages Linear Weighted Average Moving averages are popular for identifying price trends and are versatile in nature. They smooth out fluctuations in market prices thereby making it easier to determine underlying trends. Their other function is to signal significant changes in the direction as early as possible. Types of Moving Averages There are different types of moving averages that vary in the way these are calculated, but how each average is interpreted remains the same. The calculations only differ in regards to the weight placed on the price data, varying from equal weight applied to each price point to more weight being applied to recent data. The three most common types of moving averages are: Simple Moving Average (SMA) This is the most common method used to calculate the moving average of prices. It simply takes the sum of all of the past closing prices over a given time period and divides the result by the number of prices used in the calculation. For example, in a 10-day moving average, the last 10 closing prices are added together and then divided by 10. As you can see in Figure 14.3 below, a trader is able to make the average less responsive to changing prices by increasing the number of periods used in the calculation. Increasing the number of time periods in the calculation is one of the best ways to gauge the strength of the long-term trend and the likelihood that it will reverse. This moving average indicator is the least common method out of the three and is used to address the problem of equal weights. The linear weighted moving average is calculated by taking the sum of all the closing prices over a certain time period and multiplying them with the position of the data point and then dividing the total by the sum of the number of periods. For example, in a five-day linear weighted average, today's closing price is multiplied by 5, yesterday's price by 4 and so on until the first day in the period range is reached. These numbers are then added together and divided by the sum of the multipliers. Exponential Moving Average (EMA) This moving average calculation method uses a smoothing factor to place a higher weight on recent data points and is regarded as much more efficient method than the linear weighted average. Having an understanding of the calculation is not generally required for most traders because most charting packages do the calculation for you. The most important thing to remember about the exponential moving average is that it is more responsive to new information relative to the simple moving average. This responsiveness is one of the key factors of why this is the moving average of choice among many technical traders. As you can see in Figure 14.4 below, a 15-period EMA rises and falls faster than a 15-period SMA. This slight difference doesn't seem like much, but it is an important factor to be aware of since it can affect returns

31 1. Another method of determining momentum is to look at the order of a pair of moving averages. When a short-term average is above a longer-term average, the trend is up. On the other hand, a long-term average above a shorter-term average signals a downward movement in the trend. Major Uses of Moving Averages Figure 14.4 Exponential Moving Average 2. Moving average trend reversals are interpreted in two main ways: when the price moves through a moving average and when it moves through moving average cross overs. The first common signal is when the price moves through an important moving average. For example, when the price of a security that was in an uptrend falls below a 50-period moving average, like in Figure 14.6 below, it is a sign that the uptrend may be reversing. The following are some of the major uses of Moving Averages: 1. To identify current trends and trend reversals as well as to set support and resistance levels 2. To quickly identify whether a security is moving in an uptrend or a downtrend depending on the direction of the moving average. As you can see in Figure 14.5 below, when a moving average is heading upward and the price is above it, the security is in an uptrend. Conversely, a downward sloping moving average with the price below can be used to signal a downtrend. 5. Moving averages are a powerful tool for analyzing the trend in a security. They provide useful support and Figure 14.5 resistance points and are very easy to use. The most common time frames that are used when creating moving averages are the 200-day, 100-day, 50-day, 20-day and 1O-day.The 200-day average is thought to be a good measure of a trading year, a 1OO-dayaverage of a half a year, a 50-day average of a quarter of a year, a 20-day average of a month and 1O-day average of two weeks. 6. Moving averages help technical traders to smooth out some of the noise that is found in day-to-day price Figure 14.5 movements, giving traders a clearer view of the price trend. Trends in Moving Averages The three basic trends that are followed in moving averages to track the various investment horizons are: Long-term averages 61 62

32 On the monthly chart shown below (Figure 14.7), the 11-month moving average tracks the long-term trend. Figure 14.9 Short-term average Medium-term averages Figure 14.7 Long term average On the weekly chart above, the 11-week moving average tracks the medium-term trend. However, instead of using three separate charts to illustrate the three basic trends, we often use a daily chart displaying all three moving averages. On the daily chart (as shown in Figure below), the 11-month moving average equals the 233-day moving average, the 11-week average equals the 55-day average and the 11-day remains the 11-day moving average. Moving Average Crossover Figure Daily chart displaying all the three moving averages. Short-term averages Figure 14.8 Medium-term average On the daily chart on the right, the 11-day moving average tracks the short-term trend

33 Chapter 15 MOMENTUM The three moving averages discussed above are shown again here on the daily chart (Figure 14.10) - the 11- day moving average (short-term trend), the 55-day moving average (medium-term trend) and the 233- day (long-term trend) moving average which tracks the long-term trend (we also track the more popular 200- day moving average). Displaying the three moving averages on one chart provides important signals based on the moving average crossovers. What is Momentum? In physics, momentum is measured by the rate of increase and decrease in the speed of an object. In financial markets, it is measured by the speed of the price trend, i.e. whether a trend is accelerating or decelerating, rather than the actual price level itself. BUY and SELL signals are given: When the price crosses the moving average. When the moving average itself changes direction and When the moving averages cross each other A short-term buy signal (B 1) is given when the price rises above the 11-day moving average. However, the buy signal is confirmed when the 11-day average itself starts rising. The sell signals (51) are given in the opposite direction. A medium-term buy signal (B2) is given when the price rises above the 55-day moving average and is confirmed when the 55-day average itself starts rising and the 11-day average crosses above the 55-day average. The sell signals (52) are given in the opposite direction. Momentum can also be described as the rate of acceleration of a security's price or volume. Once a trader sees an acceleration in a stock's price, earnings, or revenues, the trader will often take a long or short position in the stock with the hope that its momentum will continue in either an upwards or downwards direction. We have noted that moving averages are lagging indicators and give signals after the price trend has already turned. On the other hand, momentum indicators lead the price trend. They give signals before the price trend turns. Once momentum provides a signal, it has to be confirmed by a moving average crossover. Instead of calculating the moving average of the sum of 5 days, we calculate the difference over a constant 5-day period for a 5-day rate of change. This is shown on the chart below (Figure 15.1) together with the zero line. If today's price is higher than that of five days ago, the indicator is positive, i.e. above the zero line. If the price continues to rise compared to that of five days earlier, the indicator rises. If the price today is lower than that of five days ago, the indicator is negative, i.e. below the zero line. The rate of change oscillator is rather volatile. Therefore, we have smoothed it out (see thick-curved line) so that it provides easy-to-read directional change. A long-term buy signal (B3) is given when the price rises above the 233-day moving average. However, the signal is confirmed when the 233-day average itself starts rising and the 55-day average crosses above the 233-day moving average. The sell signals (53) are given in the opposite direction. Figure

34 Chapter 16 What are indicators? NDICATORS AND OSCILLATORS Indicators are calculations based on the price and the volume of a security that measure such factors as money flow, trends, volatility and momentum. Indicators are used as a secondary measure to the actual price movements and add additional information to the analysis of securities. Uses of indication Indicators are used in two main ways: 1. To confirm price movement and the quality of chart patterns 2. To form buy and sell signals Types of indicators There are two main types of indicators: 1. Leading - A leading indicator precedes price movements, giving them a predictive quality. It is thought to be the strongest during periods of sideways or non-trending trading ranges. 2. Lagging - A lagging indicator is a confirmation tool because it follows price movement. It is still useful during trending periods. Types of Indicator Constructions There are also two types of indicator constructions - those that fall in a bounded range and those that do not. The ones that are bound within a range are called oscillators - these are the most common type of indicators. Oscillator indicators have a range, for example between zero and 100, and signal periods where the security is overbought (near 100) or oversold (near zero). Non-bounded indicators still form buy and sell signals along with displaying strength or weakness, but they vary in the way they do this. Crossovers and Divergence The two main ways that indicators are used to form buy and sell signals in technical analysis is through crossovers and divergence. Crossovers are the most popular and are reflected when either the price moves through the moving average, or when two different moving averages cross over each other. The second way indicators are used is through divergence, which happens when the direction of the price trend and the direction of the indicator trend are moving in the opposite direction. This signals to the indicator users that the direction of the price trend is weakening. Indicators that are used in technical analysis provide an extremely useful source of additional information. These indicators help identify momentum, trends, volatility and various other aspects in a security to aid the technical analysis of trends. It is important to note that while some traders use a single indicator solely for buy and sell signals, these are best used in conjunction with price movement, chart patterns and other indicators. Moving Average Convergence Divergence MACD Moving average convergence divergence (MACD) is one of the most well known and widely used indicators in technical analysis. This indicator comprises of two exponential moving averages, which helps to measure momentum in the security. MACD can simply be defined as the difference between these two moving averages plotted against a centerline (The centerline is the point at which the two moving averages are equal). Along with the MACD and the centerline, an exponential moving average of the MACD itself is plotted on the chart. The idea behind this momentum indicator is to measure short-term momentum compared to longer term momentum to help signal the current direction of momentum. MACD = Short-term moving average - Long-term moving average The findings of the MACD can be enumerated as under: 1. When the MACD is positive, it signals that the short-term moving average is above the long-term moving average and suggests an upward momentum. 2. The opposite holds true when the MACD is negative - this signals that the short-term is below the long term and suggests a downward momentum. 3. When the MACD line crosses over the centerline, it signals a crossing in the moving averages. The most common moving average values used in the calculation are the 26-day and 12-day exponential moving averages. The signal line is commonly created by using a 9-day exponential moving average of the MACD values. These values can be adjusted to meet the needs of the technician and the security. For more volatile securities, short-term averages are used while less volatile securities should have longer averages

35 MACD Histogram The MACD histogram is plotted on the centerline and is represented by bars. Each bar is the difference between the MACD and the signal line or, in most cases, the 9-day exponential moving average. The higher the bars are in either direction, the more momentum is present behind the direction in which the bars point. However, the standard calculation for RSI uses 14 trading days as the basis, which can be adjusted to meet the needs of the user. If the trading period is adjusted to use fewer days, the RSI will be more volatile and will be used for shorter term trades. On-balance Volume OBV On-Balance Volume, an indicator developed by Joe Granville, is a method used in technical analysis to detect momentum, the calculation of which relates volume to price change. OBV provides a running total of volume and shows whether this volume is flowing in or out of a given security. The on-balance volume (OBV) indicator is a well-known technical indicator that reflects movements in volume. It is also one of the simplest volume indicators to compute and understand. Figure 16.1 Moving Average Convergence Divergence Indicator Relative Strength Index RSI The relative strength index (RSI) is another widely used and well-known momentum indicator in technical analysis. RSI helps to signal the overbought and oversold conditions in a security. As seen in Figure 16.2 below, the RSI indicator ranges from zero and 100. An asset is deemed to be overbought once the RSI approaches the 70 level, meaning that it may be getting overvalued and is a good candidate for a pullback. Likewise, if the RSI approaches 30, it is an indication that the asset may be getting oversold and therefore likely to become undervalued. Figure 16.3 On Balance Volume Indicator OBV attempts to detect when a financial instrument (stock, bond, etc.) is being accumulated by a large number of buyers or sold by many sellers. Traders will use an upward sloping OBV to confirm an uptrend, while a downward sloping OBV is used to confirm a downtrend. Finding a downward sloping OBV while the price of an asset is trending upward can be used to suggest that the "smart" traders have started exiting from their positions and that a shift in trend may be expected to come. Stochastic Oscillator Figure 16.2 Relative Strength Index Indicator Stochastic Oscillator is a technical momentum indicator that compares a security's closing price to its price range over a given time period. The oscillator's sensitivity to market movements can be reduced by adjusting the time period or by taking a moving average of the result

36 Chapter 17 FASCINATING FIBONACCI The theory behind this indicator is that in an upward-trending market, prices tend to close near their high, and during a downward-trending market, prices tend to close near their low. The stochastic oscillator (Figure 16.4 below) is plotted within a range of zero and 100 and signals overbought conditions above 80 and oversold conditions below 20. Basically, it contains two lines. The first line is the %K, which is essentially the raw measure used to formulate the idea of momentum behind the oscillator. The second line is the %0, which is simply a moving average of the %K. The %0 line is considered to be the more important of the two lines as it is seen to produce better signals. The stochastic oscillator generally uses the past 14 trading periods in its calculation but can be adjusted to meet the needs of the user. Transaction signals occur when the %K crosses through a three-period moving average called the "%D". Figure 17.1 Figure 16.4 Stochastic Oscillator What does Fibonacci Numbers / Lines mean? This indicator is calculated with the following formula: %k = 100{(C-l14)/(H14-L14)} C = the most recent closing price L14 = the low of the 14 previous trading sessions H14 = the highest price traded during the same 14-day period. Leonardo Fibonacci, an Italian mathematician born in the 12th century, is known to have discovered the Fibonacci numbers - a sequence of numbers where each successive number is the sum of the two previous numbers. Example: 0, 1, 1, 2, 3, 4, 5, 8, 13, 21, 34, 55, 89, 144 For reasons unknown, these numbers play an important role in determining relative areas where the prices of financial assets experience large price moves or change direction. These numbers possess a number of interrelationships, such as the fact that any given number is approximately times the preceding number. %D = 3 period moving average of %K 71 72

37 Fibonacci studies Interpretation of the Fibonacci numbers in technical analysis anticipates changes in trends as prices tend to be near lines created by the Fibonacci studies. The four popular Fibonacci studies are arcs, fans, retracements and time zones: Fibonacci Arc This is a charting technique consisting of 3 curved lines that are drawn for the purpose of anticipating key support and resistance levels, and areas of ranging. Fibonacci fans are created by first drawing a trendline through 2 points (usually the high and low in a given period), and then by dividing the vertical distance between the two points by the key Fibonacci ratios of 38.2%, 50% and 61.8%. The results of these divisions each represent a point within the vertical distance. The three 'fan' lines are then created by drawing a line from the leftmost point to each of the 3 representing a Fibonacci ratio. Fibonacci Retracement This is a charting technique used in technical analysis that refers to the likelihood that a financial asset's price will retrace a large portion of an original move and find support or resistance at the key Fibonacci levels before it continues in the original direction. These levels are created by drawing a trendline between 2 extreme points and then dividing the vertical distance by the key Fibonacci ratios of 23.6%, 38.2%, 50%, 61.8% and 100%. Figure 17.2 Fibonacci Arc Fibonacci arcs are created by first drawing an invisible trendline between two points (usually the high and low in a given period), and then by drawing 3 curves that intersect this trendline at the key Fibonacci levels of 38.2%, 50% and 61.8%. Transaction decisions are made when the price of the asset crosses through these key levels. Fibonacci Fan This is a charting technique that consists of 3 diagonal lines that use Fibonacci ratios to help identify key levels of support and resistance Figure 17.4 Fibonacci Retracement Fibonacci retracement is a very popular tool used by many technical traders to help identify strategic places for transactions to be placed, target prices or stop losses. The notion of retracement is used in many indicators such as Tirone levels, Gartley patterns, Elliott Wave theory, etc. Fibonacci Time Zones This is an indicator used by technical traders to identify periods in which the price of an asset will experience a significant amount of movement. This charting technique consists of a series of vertical lines that correspond to the sequence of numbers known as Fibonacci numbers (1, 2, 3, 5,8, 13, 21, 34, etc.). Once a trader chooses a starting position (most commonly following a major move) on the chart, a vertical line is placed on every subsequent day that corresponds to the position in the Fibonacci number sequence. Figure 17.3 Fibonacci Fan 73 74

38 Additional phenomena relating to the Fibonacci sequence includes: 1. No two consecutive numbers in the sequence have any common factors. 2. The sum of any ten numbers in the sequence is divisible by The sum of all Fibonacci numbers in the sequence +1 equals the Fibonacci number two steps ahead. Fibonacci arcs are created by first drawing an invisible trendline between two points (usually the high and low in a given period), and then by drawing 3 curves that intersect this trendline at the key Fibonacci levels of 38.2%, 50% and 61.8%. Transaction decisions are made when the price of the asset crosses through these key levels. Fibonacci Fan Figure 17.5 Fibonacci Time Zones 4. The square of a Fibonacci number minus the square of the second number below it in the sequence is always a Fibonacci number. There are numerous relationships within this series, but the most important is or It is known as the Golden Ratio or Golden Mean and governs nature's growth patterns. This is a charting technique that consists of 3 diagonal lines that use Fibonacci ratios to help identify key levels of support and resistance Properties of Fibonacci Numbers This sequence of numbers has some very important properties. 1. The ratio of any number to the next number in the sequence is to 1 and to the next lower number is The ratio between alternative numbers in the sequences is or its inverse These numbers have some special relationship of their own such as: = = x = x = x1.618=