$ INTRODUCTION $
Charles Dow and his partner Edward Jones founded Dow Jones & Company in 1882. Most technicians and students of the markets concur that much of what we call technical analysis today has its origins in theories first proposed by Dow around the turn of the century. Dow published his ideas in a series of editorials he wrote for the Wall Street Journal. Most technicians today recognize and assimilate Dow's basic ideas, whether or not they recognize the source. Dow Theory still forms the cornerstone of the study of technical analysis, even in the face of today's sophisticated com­puter technology, and the proliferation of newer and supposedly better technical indicators.
On July 3, 1884, Dow published the first stock market aver­age composed of the closing prices of eleven stocks: nine railroad companies and two manufacturing firms. Dow felt that these eleven stocks provided a good indication of the economic health of the country. In 1897, Dow determined that two separate indices would better represent that health, and created a 12 stock industrial index and a 20 stock rail index. By 1928 the industrial
index had grown to include 30 stocks, the number at which it stands today. The editors of The Wall Street Journal have updated the list numerous times in the ensuing years, adding a utility index in 1929. In 1984, the year that marked the one hundredth anniversary of Dow's first publication, the Market Technicians Association presented a Gorham-silver bowl to Dow Jones & Co. According to the MTA, the award recognized "the lasting contri­bution that Charles Dow made to the field of investment analy­sis. His index, the forerunner of what today is regarded as the leading barometer of stock market activity, remains a vital tool for market technicians 80 years after his death."
Unfortunately for us, Dow never wrote a book on his the­ory. Instead, he set down his ideas of stock market behavior in a series of editorials that The Wall Street Journal published around the turn of the century. In 1903, the year after Dow's death, S.A. Nelson compiled these essays into a book entitled The ABC of Stock Speculation. In that work, Nelson first coined the term "Dow's Theory." Richard Russell, who wrote the introduction to a 1978 reprint, compared Dow's contribution to stock market theo­ry with Freud's contribution to psychiatry. In 1922, William Peter Hamilton (Dow's associate and successor at the Journal) catego­rized and published Dow's tenets in a book entitled The Stock Market Barometer. Robert Rhea developed the theory even further in the Dow Theory (New York: Barron's), published in 1932.
Dow applied his theoretical work to the stock market aver­ages that he created; namely the Industrials and the Rails. However, most of his analytical ideas apply equally well to all market averages. This chapter will describe the six basic tenets of Dow Theory and will discuss how these ideas fit into a modern study of technical analysis. We will discuss the ramifications of these ideas in the chapters that follow.
BASIC TENETS
1. The Averages Discount Everything.
The sum and tendency of the transactions of the Stock Exchange represent the sum of all Wall Street's knowl‑
edge of the past, immediate and remote, applied to the discounting of the future. There is no need to add to the averages, as some statisticians do, elaborate compilations of commodity price index numbers, bank clearings, fluc­tuations in exchange, volume of domestic and foreign trades or anything else. Wall Street considers all these things (Hamilton, pp. 40-41).
Sound familiar? The idea that the markets reflect every possible knowable factor that affects overall supply and demand is one of the basic premises of technical theory, as was mentioned in Chapter 1. The theory applies to market averages, as well as it does to individual markets, and even makes allowances for "acts of God." While the markets cannot anticipate events such as earthquakes and various other natural calamities, they quickly discount such occurrences, and almost instantaneously assimilate their affects into the price action.
2. The Market Has Three Trends.
Before discussing how trends behave, we must clarify what Dow considered a trend. Dow defined an uptrend as a situation in which each successive rally closes higher than the previous rally high, and each successive rally low also closes higher than the previous rally low. In other words, an uptrend has a pattern of rising peaks and troughs. The opposite situation, with successively lower peaks and troughs, defines a downtrend. Dow's definition has withstood the test of time and still forms the cornerstone of trend analysis.
Dow believed that the laws of action and reaction apply to the markets just as they do to the physical universe. He wrote, "Records of trading show that in many cases when a stock reach­es top it will have a moderate decline and then go back again to near the highest figures. If after such a move, the price again recedes, it is liable to decline some distance" (Nelson, page 43).
Dow considered a trend to have three parts, primary, sec­ondary, and minor, which he compared to the tide, waves, and rip­ples of the sea. The primary trend represents the tide, the sec­ondary or intermediate trend represents the waves that make up the tide, and the minor trends behave like ripples on the waves.
An observer can determine the direction of the tide by not­ing the highest point on the beach reached by successive waves. If each successive wave reaches further inland than the preceding one, the tide is flowing in. When the high point of each succes­sive wave recedes, the tide has turned out and is ebbing. Unlike actual ocean tides, which last a matter of hours, Dow conceived of market tides as lasting for more than a year, and possibly for several years.
The secondary, or intermediate, trend represents correc­tions in the primary trend and usually lasts three weeks to three months. These intermediate corrections generally retrace between one-third and two-thirds of the previous trend movement and most frequently about half, or 50%, of the previous move.
According to Dow, the minor (or near term) trend usually lasts less than three weeks. This near term trend represents fluc­tuations in the intermediate trend. We will discuss trend concepts in greater detail in Chapter 4, "Basic Concepts of Trends," where you will see that we continue to use the same basic concepts and terminology today.
3. Major Trends Have Three Phases.
Dow focused his attention on primary or major trends, which he felt usually take place in three distinct phases: an accumulation phase, a public participation phase, and a distribution phase. The accumulation phase represents informed buying by the most astute investors. If the previous trend was down, then at this point these astute investors recognize that the market has assimi­lated all the so-called "bad" news. The public participation phase, where most technical trend-followers begin to participate, occurs when prices begin to advance rapidly and business news improves. The distribution phase takes place when newspapers begin to print increasingly bullish stories; when economic news is better than ever; and when speculative volume and public partic­ipation increase. During this last phase the same informed investors who began to "accumulate" near the bear market bot­tom (when no one else wanted to buy) begin to "distribute" before anyone else starts selling.
Students of Elliott Wave Theory will recognize this divi­sion of a major bull market into three distinct phases. R. N. Elliott elaborated upon Rhea's work in Dow Theory,to recognize that a bull market has three major, upward movements. In Chapter 13, "Elliott Wave Theory," we'll show the close similari­ty between Dow's three phases of a bull market and the five wave Elliott sequence.
4. The Averages Must Confirm Each Other.
Dow, in referring to the Industrial and Rail Averages, meant that no important bull or bear market signal could take place unless both averages gave the same signal, thus confirming each other. He felt that both averages must exceed a previous secondary peak to confirm the inception or continuation of a bull market. He did not believe that the signals had to occur simultaneously, but rec­ognized that a shorter length of time between the two signals pro­vided stronger confirmation. When the two averages diverged from one another, Dow assumed that the prior trend was still maintained. (Elliott Wave Theory only requires that signals be generated in a single average.) Chapter 6, "Continuation Patterns," will cover the key concepts of confirmation and diver­gence. (See Figures 2.1 and 2.2.)
5. $ Volume Must Confirm the Trend $.
Dow recognized volume as a secondary but important factor in confirming price signals. Simply stated, volume should expand or increase in the direction of the major trend. In a major uptrend, vol­ume would then increase as prices move higher, and diminish as prices fall. In a downtrend, volume should increase as prices drop and diminish as they rally. Dow considered volume a secondary indicator. He based his actual buy and sell signals entirely on clos­ing prices. In Chapter 7, "Volume and Open Interest," we'll cover the subject of volume and build on Dow's ideas. Today's sophisti­cated volume indicators help determine whether volume is increasing or falling off. Savvy traders then compare this infor­mation to price action to see if the two are confirming each other.

$ INTRODUCTION $ The purpose of this writing is to illustrate what Market Profile is and to define its underlying principles. Before the early 1980s, the only technical tools available were the bar chart and the point and figure chart. Since then Market Profile®1 was intro­duced to expand the arsenal of technical tools. Market Profile is essentially a statistical approach to the analysis of price data.2 For those without a statistics background, a familiar example may be helpful. Consider a group of students taking an exam. Typically, some score very high (say 90 or higher), some score very low 60 or lower), but most scores tend to be clustered around the average score (say 75). A histogram can be used to depict the fre­quency distribution of these test scores in a "statistical picture" (Figure B.1).As can be seen, the most frequent score, or modal score, is 75 (6 students) while the range of scores is defined by the low­est and highest scores (55 and 95). Note how the scores distrib­ute evenly around the modal score. For a perfectly symmetric distribution, the modal score will be equal to the mean, or aver­age score. Next observe that the distribution is "bell-shaped," the telltale sign of a normal distribution. For a perfect normal distribution, specific standard deviation intervals correlate to specific numbers of observations. For example, if the test scores are, in fact, perfectly normally distributed, then 68.3% of these scores will fall within one (1) standard deviation of the mean. While actual data is unlikely to form a perfect normal distri­bution, it is often close enough that these relationships can be employed.Prices, like other physical measurements (e.g., school test grades, population heights, etc.), distribute around a mean price level as well. What is the Market Profile graphic? Visualize it as simply, a frequency distribution of prices displayed as a price his­togram turned on its side
The centerpiece of the Market Profile graphic is the (bell‑shaped) normal curve used to display the evolving price distribu‑tion. Once the normal curve assumption is acknowledged, amodal or average price can be identified, a price dispersion (stan‑dard derivation) can be computed and probability statements canbe made regarding the price distribution. For example, virtuallyall values fall within three (3) standard deviations of the averagewhile about 70% (68.3% to be exact) fall within one (1) standarddeviation of the average (see Figure B.3).
Market Profile provides a picture of what's happening here and now in the marketplace. In its pursuit of promoting trade, the market is either in equilibrium or moving toward it. The profile's natur­al tendency toward symmetry defines, in a simple way, the degree of balance (equilibrium) or imbalance (disequilibri­um) that exists between buyers and sell­ers. As the market is dynamic, the profile graphic portrays equilibrium as periods of market balance—when price distribu­tions are symmetric, and represents dise­quilibrium as periods of market imbal­ance—when price distributions are not symmetric or are skewed.
Market Profile is not a trading system nor does it provide trade recommendations. The aim of the profile graphic is to allow the user to witness a market's developing value on price reoccur­rence over time. As such, Market Profile is a decision support tool requiring the user to exercise personal judgment in the trading process.
MARKET PROFILE GRAPHIC
The Market Profile format organizes price and time into a visual representation of what happens over the course of a single ses­sion. It provides a logical framework for observing market behav­ior in the present tense displaying price distributions over a period of time. The price range evolves both vertically and horizontally throughout the session. How is a profile graphic constructed?
Consider a 4 period bar chart (see Figure B.3a). This tradi­tional bar chart can be converted to a profile graphic as follows: (1) assign a letter for each price within each period's price range, letter A for the 1st period, B for the 2nd, and so on (see Figure B.3b) and then (2) collapse each price range to the leftmost or first col­umn (see Figure B.3c). The completed profile graphic reflects prices on the left and period frequency of price occurrence on the right, represented by the letters A through D.‑
sents a Time Price Opportu­nity or TPO to identify a specific price at which the market traded during a specific time period (e.g., in B period prices traded between 163 and 166). These TPOs are the basic units of analysis for the day's activity. In other words, each TPO is an opportunity created by the
market at a certain time Figure B.3c
and certain price. Market
Profile distributions are
constructed of TPOs. The Chicago Board of Trade (CBOT) assigns a letter to each half-hour trading period on a 24 hour basis; upper­case letters A through X represent the half-hour periods from midnight to noon while lowercase letters from a through x repre­sent the half-hour periods from noon to midnight.3
MARKET STRUCTURE
When you visit a commodities trading pit on a busy day, you observe what is best described as "controlled chaos." Beneath the screaming and gesturing locals and other traders, there is a describable process. Think of the market as a place where partici­pants with differing price needs and time constraints compete with each other to get business done. Emotions can run high as anxiety levels soar.
The Market Profile concept was introduced by Mr. Steidlmayer in an attempt to help describe this process. As a..
CBOT floor trader (local) and student of market behavior, he observed recurring patterns of market activity, which ultimately lay the foundation for his understanding of the market. Since the CBOT trading floor conducts trade in an auction-like man­ner, he defined Market Profile principles in auction terms. For example, an off-the-floor trader would describe an advancing market as one that is rallying or trading up, whereas Mr. Steidlmayer would instead say something like, "the market con­tinues to auction up, advertising for sellers to appear in order to shut off buying."
To explain why a trading pit auction process works the way it does, he invented some new terms unfamiliar to off-the­floor traders. He began with a definition of a market's purpose, which is to facilitate trade. Next, he defined some operational procedures, namely that the market operates in a dual auction mode as prices rotate around a fair or mean price area (i.e., sim­ilar to the way school grades were distributed). Lastly, he defined the behavior characteristics of market participants, namely that traders with a short term time frame seek a fair price, while traders with a longer term time frame seek an
advantageous price.
MARKET PROFILE ORGANIZING PRINCIPLES
Auction Setting: The purpose of the marketplace is to facilitate or promote trade. All market activity occurs within this auction setting. Initially, as price moves higher, more buying comes in, as price moves lower, more selling comes in. The market moves up to shut off buying (i.e., auctioning up until the last buyer buys) and moves down to shut off selling (i.e., auctioning down until the last seller sells). The market actually operates through a dual auction process. When price moves up and more buying comes in, the up-move advertises for an opposite response (i.e., selling) to stop the directional move. The opposite is true when price moves down.
Continuous Negotiation: When a mar­ket moves directionally it establishes price parameters, an unfair high and an unfair low, and then trades between them to establish a fair value area. All trade takes place through this negotiating process and remains within these parame­ters until one side or the other side is eventually taken out (i.e., a new high or new low is formed). (see Figure B.4.)
Market Balance and Imbalance: The market is either in equilibrium or working toward equilibrium between buyers and sellers. To facilitate trade, the market moves from a state of balance (equilibrium) to one of imbalance (dise­quilibrium ) and back to balance again. This pattern of market behavior occurs in all times frames, from intraday ses­sion activity to single session activity to aggregated or consolidated sessions Figure B.4 activity which form the longer term
auction.
Time Frames and Trader Behavior: The concept of differ­ent time frames was introduced to help explain the behavioral patterns of market participants. Market activity is divided into two timeframe categories, short term and longer term. The short term activity is defined as day time frame activity where traders are forced to trade today (e.g., locals, day traders and options traders on expiration day fall into this category). With limited time to act, the short term trader is seeking a fair price. Short term buyers and sellers do trade with each other at the same time and at the same price. Longer term activity is defined by all other timeframe activity (e.g., commercials, swing traders, and all other position traders fall into this category). Not forced to trade today and with time as an ally, these traders can seek a more advantageous price. In pursuit of their interests, longer term buyers seek lower prices
while longer term sellers seek higher prices. As their price objec­tives differ, longer term buyers and sellers generally do not trade with each other at the same price and at the same time. It is the behavioral interaction between these two distinct timeframe types of activity that causes the profile to develop as it does.
The Short Term Trader and Longer Term Trader Play Different Roles: Short term and longer term traders play key, but different, roles in facilitating trade. A market's initial balance (i.e., a place where two-sided trade can occur) is usually estab­lished in the first hour of trade by short term buyers and sellers (day timeframe activity) in their pursuit of a fair price. Most of the day's activity occurs in the fair price or value area. Prices above and below this developed fair value area offer opportuni­ty and are advantageous to longer term traders. With time on their side, longer term traders can either accept or reject prices away from fair value. By entering the market with large enough volume, longer term buyers and sellers can upset the initial bal­ance, thereby extending the price range higher or lower. The longer term trader is responsible for the way the day's range develops and for the duration of the longer term auction. In other words, the role of the longer term trader is to move the market directionally.
Price and Value: The distinction between price and value defines a market-generated opportunity. There are two kinds of prices: 1) those that are accepted—defined as a price area where the market trades over time and 2) those that are rejected—defined as a price area where the market spends very little time. A rejected price is considered excessive in the market—defined as an unfair high or unfair low. Price and value are all but synony­mous for short term traders as they ordinarily trade in the fair value area. For longer term traders, however, the concept that price equals value is often inaccurate. Price is observable and objective while value is perceived and subjective, depending upon the particular needs of longer term traders. For example, a price at the top of today's range, while excessive or unfair for today, is cheap to the longer term trader who believes that prices next week will be much higher (i.e., today's price is below next week's anticipated value).The longer term trader distinguishes between price and value by accepting or rejecting current prices away from his per­ception of fair value. Recall that rising prices advertise for sellers while falling prices advertise for buyers. When the longer term trad­er responds to an advertised price, this behavior is expected and is referred to as responsive. On the other hand, if the longer term trad­er did the opposite (i.e., buy after prices rose or sell after prices declined), then this unexpected activity is referred to as initiating. Classifying longer term activity as responsive or initiating relative to yesterday's or today's evolving value area provides anecdotal evi­dence of longer term trader confidence. The more confident the trader becomes, the more likely he is to take initiating action.RANGE DEVELOPMENT AND PROFILE PATTERNS
Since market activity is not arbitrary, it's not surprising that over time recognizable price patterns reveal themselves. A skillful trad­er able to anticipate such pattern development in its early stage may be able to capitalize. Mr. Steidlmayer loosely identifies the following daily range development patterns:
1. A normal day occurs when the longer term trader is rela­tively inactive. The day's range is established in the pioneer range (defined as the first column of prices) during the ses­sion's first half-hour period of trade. The short term trader establishes the initial balance, the unfair high and low, and then prices rotate between these parameters for balance of the day (see Figure B.6: Panel #1—Orange Juice).
2. A normal variation day occurs when the longer term trad­er is more active and extends the range beyond the initial balance. In this instance, the short term traders initial bal­ance parameters do not hold and there is some directional movement which extends the range and sets a new high or new low parameter. As a rule, the range extension beyond the initial balance can be anywhere from a couple of ticks to double the initial balance. This profile type is probably the most common (see Figure B.6: Panel #2—Dow Jones Industrial Average).
3. A trend day occurs when the longer term trader extends the range successively further. In this instance, the range is considerably more than double the initial balance with the longer term trader controlling direction as the market con­tinues its search for a fair price. Here the market moves in one direction and closes at or near the directional extreme (see Figure B.6: Panel #3—Japanese Yen).
4. A neutral day occurs when the longer term trader extends the range after the initial balance in one direction, then reverses and extends the range in the opposite direction. Neutral days indicate trader uncertainty and occur when the market probes or tests for price trend continuation or change TRACKING LONGER TERM MARKET ACTIVITY
With the exception of option sellers who profit when prices remain static, the profit strategy of most traders requires direc­tional price movement. The trader wins when he gets the direc­tion right and loses when he is incorrect. Because the longer term trader is responsible for determining the market's directional movement, we monitor this activity to help detect evidence of a price trend. After identifying and evaluating longer term trader activity, an educated conclusion regarding price direction can be reached. We begin the process by identifying the longer term trad­er's influence in today's session and then considering how that influence extends into the future.
• Influence in day's range development: The profile graph­ic helps identify longer term trader behavior during daily range development. By monitoring longer term activity throughout the range, particularly at the extremes, at range extension, and after value area completion, we can deter­mine whether longer term buyers or sellers are more active and hence control market direction. Activity at the extremes provides the clearest indication of longer term trader influence, followed by range extension and then value area buying and selling.1. Extremes are formed when the longer term trader com­petes with the short term trader for opportunities at a par­ticular price level (which later becomes either the session high or low). A minimum of two single prints is required to establish an extreme. The more eager the longer term trader is in this price competition, the more the single prints and the longer the single print extreme. Anything less than two prints suggests that the longer term trader is not very interested in competing at that price. A local top or bottom is formed when only one single print defines the top or bottom of the range. This condition implies that the market offered a price opportunity which no one really wanted (i.e., no evidence of competition.
2. Range Extension occurs when the longer term trader enters the market with enough volume to tip the initial balance and extend the range up or down. Range exten­sion up indicates longer term buying while range exten­sion down indicates longer term selling. However, there are occasions when both the longer term buyer and sell­er are active at a range extreme, but not at the same price and time (recall that longer term buyers and sellers gen­erally do not trade with each other). For example, if an extreme is formed after a range extension up, the market moves up first to shut off buying and then moves down to shut off selling. This is an example of both longer term buyers and sellers trading in the same price area but at different times. Both kinds of activity at the extremes are identified to evaluate the impact of longer term buying and selling (see Figure B.7: Panel #2—Coffee).
3. The Value Area is determined each trading session by price rotations around the modal price (i.e., the price with the highest TPO count or the fairest price). The value area is computed by counting 70% of all TPOs sur­rounding the fairest price. In other words, the value area is an estimate of fair value which is approximated by one standard deviation of the session's trading volume (recall the student example earlier). When a longer term trader makes a trade in the value area, he is buying low or selling high in relation to a longer term view, not in relation to today's value. This behavior creates an imbal­ance in today's value area. Longer term trader activity is measured by counting TPOs. The following procedure can be used to determine which side contains the longer term imbalance, 1) a line is drawn through the fairest price, and 2) TPOs are counted on either side of the fairest price until a single print is encountered. The imbalance is assigned to the side with the smaller num­ber of TPOs because the longer term trader activity rep­resents the smaller percentage of total trade in the value area. For example, if the TPO count was 22 above and 12
below the fairest price, that would indicate net TPO sell­ing with a mild bias toward lower prices (see Figure B.7: Panel #3—S&P 500 Index). Note that TPO buying and selling in the value area is not applicable on trend days, as the market is still in search of a fair value area.
After identifying and evaluating longer term trader activi­ty correctly in today's profile graphic, the user can readily deter­mine whether longer term buyers or sellers were in control of the current trading session.
• Influence beyond today: The profile graphic also helps identify longer term trader behavior beyond today's range development. A key goal of the trader is to determine whether the current market price trend will continue or is likely to change. A change in market direction is a reversal of the current price trend. The standard technical approach to trend assessment, without Market Profile, is to draw an appropriate trendline and monitor subsequent price action against it. Unless the trendline is violated, the current price trend is expected to continue. Trendline analysis is the most important of basic technical tools, particularly given its uni­versal usage and applicability to different time intervals (i.e., hourly, daily, weekly, monthly, etc.).
Market Profile, on the other hand, offers an alternative approach to traditional trend analysis by evaluating market activity over different time periods. In its simplest form, an evaluation of the profile graphic on consecutive days can help define the start or continuation of the short term price trend. For example, if today's value area is higher than yes­terday's value area, then the current market price trend is up. Moreover, if tomorrow's value area is higher than today's, then the current market uptrend has continued. By monitoring market activity in this fashion, the trader is able to readily identify trend continuation or change. Similarly by combining daily consecutive profile graphics into a larger cumulative profile graphic, an evolving picture of longer term balance or imbalance emerges. The profile graphic in Figure B.5 (Sugar) on page 483 illustrate this
point. A cursory review of the individual sessions (2/10­2/13) in the upper panel suggest an uptrending market without a hint of reversal. When these four (4) consecutive sessions are combined (lower panel), however, a cumulative balanced picture springs forth. Once balanced, a market moves to a state of imbalance which, more often than not, begins after a final test at the fairest price.
CONCLUSION
The Market Profile method can be used to analyze any price data series for which continuous transaction activity is available. This includes listed and unlisted equities, U.S. government notes and bonds (prices or yields), commodity futures and options, where applicable. The profile graphic presents the movement of prices, per unit of time, in two dimensions—vertically (i.e., directionally) and horizontally (i.e., frequency of occurrence). When price action is viewed in this way, a picture of price discovery unfolds which is unavailable in the traditional one dimensional (vertical) bar chart.
The profile graphic offers unique advantages over the stan­dard bar chart:
· The symmetry attribute of the profile graphic allows the trader to assess the market's state of balance (or imbalance) in any timeframe. When a market is symmetric, a condi­tion of balance or equilibrium exists between buyers and sellers. A market imbalance implies price trend continua­tion, as the market works toward a new equilibrium. Market balance, however, is fleeting and implies market change or a directional move (either up or down) is likely to occur, a signal for traders to consider employing trend fol­lowing methodologies.
· Every trend change occurs at a single moment in time, not conveniently at the end of the hour, day, week or month. The profile graphic can be used to more accurately identify that specific time where control changed hands between
buyers and sellers. By pinning down such control shifts, the profile graphic allows the trader to identify key support and resistance levels.
In short, the profile graphic provides a substantial amount of price information per unit of time, allowing the trader to iden­tify patterns and dynamics which would not be readily apparent using other methods.

$$Technical Indicators $$
This appendix introduces several more advanced technical meth­ods that can be used by themselves or with other technical stud­ies. As with any technical approach, it is always recommended that investors do their own independent testing and research before actually investing.
DEMAND INDEX (DI)
Most technicians will agree that volume analysis is an important ingredient in determining a market's direction. The Demand Index (DI) is one of the early volume indicators that was developed in the 1970s by James Sibbett. The formula is quite complex (see end of this appendix). The Demand Index is the ratio of buying pres‑sure to selling pressure. When the buying pressure is greater than the selling pressure, the DI is above the zero line, which is posi­tive. Greater selling pressure means the DI is below zero, which implies prices will move lower. Most traders also look for diver­gences between the DI and prices.
Figure A.1 is a weekly chart of T-Bond futures from early 1994 until late 1997. From April to November 1994, the DI was mostly below the zero line as bonds declined from 104 to the 96 area. While prices made lower lows (line A), the DI formed high­er lows (line B). This is a classic positive, or bullish divergence, which suggested that bond prices were bottoming. The diver­gence was confirmed when the DI moved above the zero line at point 1. The DI reached its highest level for this rally in late May 1995 at point 2, and then dropped for the next six weeks before crossing below the zero line at point 3. It stayed negative for five weeks before it again turned positive. On the next rally the DI formed a significantly lower high in late November at point 4. While the DI was lower (line D), the bond contract was almost six points higher (line C). This negative or bearish divergence warned of a price peak.This indicator can also be used with stocks. The weekly chart of General Motors (Figure A.2) shows the DI plotted as a line rather than a histogram. This allows for trendlines to more easily be drawn on the indicator. I have personally found trend-line analysis of indicators to be quite valuable. Indicator trend-lines are often broken ahead of price trendlines. This was the case in late 1995 as the downtrend in the DI (line A) was broken a week before the corresponding price downtrend (line B). As this chart indicates, buying just one week earlier could have sig­nificantly improved the entry price. The DI also warned of a price high in mid-April 1996. While GM was making a new price high (line C), the DI had formed lower highs (line D). This warn­ing signal came well ahead of the serious price decline in June and July.
HERRICK PAYOFF INDEX (HPI)
This indicator was developed by the late John Herrick as a way of analyzing commodity futures through changes in the open inter­est. As discussed in Chapter 7, changes in the open interest can give traders important clues as to whether a market trend is well supported or not.
The Herrick Payoff Index uses price, volume, and open inter­est to determine money flow into or out of a given commodity. This helps the trader spot divergences between the price action and the open interest. This is often quite important as buying or selling panics can often be identified through analysis of the open interest by the Herrick Payoff Index.
The most basic interpretation of the HPI is whether it is above or below the zero line. A positive value means that the HPI is projecting higher prices and that open interest is rising along with prices. Conversely, negative readings suggest that funds are flowing out of the commodity being analyzed.
One of the more volatile commodity markets is coffee, fea­tured in Figure A.3. During March and April of 1997, the HPI had four crossings of the zero line with the last positive signal in early April (B) lasting until early June. The HPI dropped below zero in June, and even though prices were well below the highs, coffee dropped another 70 cents. Once again the HPI turned positive in late July very close to the lows. Over the next two months there were two short term signals and then another longer term sell sig­nal. This is characteristic of the HPI when used on the daily data as it will cross above and below the zero line several times before a longer lasting buy or sell signal is given.The HPI, like the Demand Index, is most effective when used on the weekly data, as fewer false signals are evident. Divergence analysis can also be used to warn the trader of a change from positive to negative money flow. There are several good examples on the weekly T-Bond futures charts (Figure A.4) that covers approximately six years of trading. The HPI stayed positive from late 1992 until late 1993. The HPI peaked in early 1993 and, when bonds were almost 10 points higher (line A), the HPI was forming a lower high (line B). This negative diver­gence warned bond traders of the decline in prices that took place in 1994. The HPI violated the zero line in late October of 1993, but then turned slightly positive in early 1994 before plunging back below the zero line. The HPI reached its lowest
level in the first half of 1994 and bottomed well ahead of prices. As prices were making lower lows (line C), the HPI was forming higher lows and therefore a positive divergence (line D). The HPI moved back into positive territory in December 1994 as bonds were very close to their lows. A negative divergence was formed in late 1995 (line F), after bonds had rallied over 25 points from the late 1994 lows. The zero line was crossed several times in 1996 and early 1997 before the HPI moved firmly into positive territory. These two examples should illustrate why the HPI and its analysis of open interest can be helpful in analyzing a com­modity market's direction.
STARC BANDS AND KELTNER CHANNELS
As discussed in Chapter 9, banding techniques have been used for many years. Two types that I prefer are based on the Average True Range. Despite this common factor, these two types of bands are used in very different ways. Average True Range is the average of true price ranges over x periods. True Range is the greatest distance from today's high to low, yesterday's close to today's high, or yes­terday's close to today's low. See Welles Wilder's New Concepts in Technical Trading Systems.
Manning Stoller, a well known expert in the commodity business, developed the Stoller Average Range Channels or starc bands. In his formula the 15 period Average True Range is doubled and added to or subtracted from a 6 period moving average (MA). The upper band is starc+; the lower is starc-. Movement outside of these bands is uncommon and indicates an extreme situation. In this manner they can be used as trading filters. When prices are near or above the starc+ band, it is a high risk time to buy and a low risk time to sell. Conversely, if prices are at or below the starc- band, then it is a high risk selling zone and a more favorable point to buy.
The weekly continuation chart of gold futures (Figure A.5) is plotted with both the starc+ and starc- bands. In Feb. 1997 at point 1, gold prices slightly overshot the starc- band. Though the price action was weak, the starc bands indicated that this was not a good time to sell. By waiting, a better selling opportunity was likely to occur. Just three weeks later gold was $22 higher and at the starc+ band (point 2). Point 2 was a low risk selling opportunity. In July (point 3), gold prices dropped well below the starc-band, but instead of declining further, prices moved sideways for the next 12 weeks. Gold prices then started to move lower from November to December 1997 and touched the starc- band three times (points 4). In all instances prices did stabilize or move higher for 1-2 weeks. These bands work well in all time frames even as short as 5 to 10 minute bar charts. Starc bands can help the trader avoid chasing the market, which almost always results in a poor entry price.
The Kellner channels were originally developed by Chester Keltner in his 1960 book How to Make Money in Commodities. Linda Raschke, a very successful commodity trader, has reintro­duced them to technicians. In her modification, the bands are also based on the average true range (ATR), but the ATR is calculat­ed over 10 periods. This ATR value is then doubled and added to a 20 period exponential moving average for the plus band and subtracted from it for the minus band.
The recommended use of the Keltner channels is much dif­ferent from the starc bands. When prices close above the plus band, a positive signal is given as it indicates a breakout in upward volatility. Conversely, when prices close below the lower band, it is negative and indicates prices will move lower. In many respects, this is just a graphical representation of a four week channel breakout system discussed in Chapter 9.Figure A-6 is a daily chart of March 1998 copper futures. Prices closed below the minus band in late October 1997 at point 1. This indicated that prices should begin a new downtrend and copper prices dropped 16 cents in the next two months There were many other closes below the minus band dur­ing this period. Until prices close above the plus band, the nega­tive signal will stay in effect. The second chart is March 1998 cof­fee prices (Figure A.7) and illustrates a positive signal at point 1. After two consecutive closes above the plus band, prices then declined to the 20 period EMA. In a rising market the 20 period EMA should act as support. Several days after the EMA was touched (point 2), coffee prices began a dramatic 30 cent rise in just a few weeks.
Both of these techniques offer an alternative approach to either percentage envelopes or standard deviation bands (like Bollinger Bands). Neither is presented as a stand-alone trading system but should be considered as additional tools of the trade.
FORMULA FOR DEMAND INDEX
The Demand Index (DI) calculates two values, Buying Pressure (BP) and Selling Pressure (SP), and then takes a ratio of the two. DI is BP/SP. There are some slight variations in the formula. Here's one version:
If prices rise:
BP = V or Volume
SP = V/P where P is the % change in price
If prices decline:
BP = V/P where P is the % change in price SP = V or Volume
Because P is a decimal (less than 1), P is modified by mul­tiplying it by the constant K.
P = P(K)
K = (3 x C)/VA
Where C is the closing price and VA (Volatility Average) is the 10 day average of a two day price range (highest high — lowest low).
If BP > SP then DI = SP/BPThe Demand Index is included on the MetaStock charting menu

Pullin
A ChecAs this book has demonstrated, technical analysis is a blend of many approaches. Each approach adds something to the analyst's knowledge of the market. Technical analysis is much like putting together a giant jigsaw puzzle. Each technical tool holds a piece of the puzzle. My approach to market analysis is to combine as many techniques as possible. Each works better in certain market situa­tions. The key is knowing which tools to emphasize in the current situation. That comes with knowledge and experience.
All of these approaches overlap to some extent and com­plement one another. The day the user sees these interrelation­ships, and is able to view technical analysis as the sum of its parts, is the day that person deserves the title of technical analyst. The following checklist is provided to help the user touch all the bases, at least in the early going. Later on, the checklist becomes second nature. The checklist is not all-inclusive, but does have most of the more important factors to keep in mind. Sound mar‑
ket analysis seldom consists of doing the obvious. The technician is constantly seeking clues to future market movement. The final clue that leans the trader in one direction or the other is often some minor factor that has gone largely unnoticed by others. The more factors the analyst considers, the better the chances of find­ing that right clue.
TECHNICAL CHECKLIST
1. What is the direction of the overall market?
2. What is the direction of the various market sectors?
3. What are the weekly and monthly charts showing?
4. Are the major, intermediate, and minor trends up, down,
or sideways?
5. Where are the important support and resistance levels?
6. Where are the important trendlines or channels?
7. Are volume and open interest confirming the price action?
8. Where are the 33%, 50%, and 66% retracements?
9. Are there any price gaps and what type are they?
10. Are there any major reversal patterns visible?
11. Are there any continuation patterns visible?
12. What are the price objectives from those patterns?
13. Which way are the moving averages pointing?
14. Are the oscillators overbought or oversold?
15. Are any divergences apparent on the oscillators?
16. Are contrary opinion numbers showing any extremes?
17. What is the Elliot Wave pattern showing?
18. Are there any obvious 3 or 5 wave patterns?
19. What about Fibonacci retracements or projections?
20. Are there any cycle tops or bottoms due? 21. Is the market showing right or left translation?
22. Which way is the computer trend moving: up, down, or sideways?
23. What are the point and figure charts or candlesticks showing?
After you've arrived at a bullish or bearish conclusion, ask yourself the following questions.
1. Which way will this market trend over the next several months?
2. Am I going to buy or sell this market?
3. How many units will I trade?
4. How much am I prepared to risk if I'm wrong?
5. What is my profit objective?
6. Where will I enter the market?
7. What type of order will I use?
8. Where will I place my protective stop?
Going through the checklist won't guarantee the right conclusions. It's only meant to help you ask the right ques­tions. Asking the right questions is the surest way of finding the right answers. The keys to successful trading are knowledge, dis­cipline, and patience. Assuming that you have the knowledge, the best way to achieve discipline and patience is doing your homework and having a plan of action. The final step is putting that plan of action to work. Even that won't guarantee success, but it will greatly increase the odds of winning in the financial markets.
HOW TO COORDINATE TECHNICAL AND
FUNDAMENTAL ANALYSIS
Despite the fact that technicians and fundamentalists are often at odds with one another, there are ways they can work together for
mutual benefit. Market analysis can be approached from either direction. While I believe that technical factors do lead the known fundamentals, I also believe that any important market move must be caused by underlying fundamental factors. Therefore, it simply makes sense for a technician to have some awareness of the fundamental condition of a market. If nothing else, the tech­nician can inquire from his or her fundamental counterpart as to what would have to happen fundamentally to justify a significant market move identified on a price chart. In addition, seeing how the market reacts to fundamental news can be used as an excel­lent technical indication.
The fundamental analyst can use technical factors to con­firm an analysis or as an alert that something important may be happening. The fundamentalist can consult a price chart or use a computer trend-following system as a filter to prevent him or her from assuming a position opposite an existing trend. Some unusual action on a price chart can act as an alert for the funda­mental analyst and cause him or her to examine the fundamental situation a bit closer. During my years in the technical analysis department of a major brokerage firm, I often approached our fundamental department to discuss some market move that seemed imminent on the price charts. I often received responses like "that can never happen" or "no way." Very often, that same person was scrambling a couple of weeks later to find fundamen­tal reasons to explain a sudden and "unexpected" market move. There's obviously room for much more coordination and cooper­ation in this area.
CHARTERED MARKET TECHNICIAN (CMT)
A lot of people use technical analysis and offer opinions on the technical condition of the various markets. But are they really qualified to do so? How would you know? After all, you wouldn't go to a doctor who didn't have a medical degree on the wall. Nor
would you consult a lawyer who hadn't passed the bar exam. Your accountant is undoubtedly a CTA. If you asked a security analyst for an assessment on a common stock, you would certainly make sure that he or she was a Chartered Financial Analyst (CFA). Why wouldn't you take the same precautions with a technical analyst?
The Market Technicians Association (MTA) resolved this question by instituting a Chartered Market Technician (CMT) pro­gram. The CMT program is a three step examination process that qualifies the analyst to carry the CMT letters after his or her name. Most professional technical analysts have gone through the pro­gram. The next time someone offers you his or her technical opin­ion, ask to see the CMT.
MARKET TECHNICIANS ASSOCIATION (MTA)
The Market Technicians Association (MTA) is the oldest and best known technical society in the world. It was founded in 1972 to encourage the exchange of technical ideas, educate the public and the investment community, and establish a code of ethics and pro­fessional standards among technical analysts. (On March 11, 1998 the MTA celebrated the 25th birthday of its incorporation. The event was highlighted by a special presentation at the New York monthly meeting by three of the organization's founding mem­bers—Ralph Acampora, John Brooks, and John Greeley.) MTA membership includes full-time technical analysts and other inter­ested parties (called affiliates). Monthly meetings are held in New York (Market Technicians Association, Inc., One World Trade Center, Suite 4447, New York, NY 10048 (212) 912-0995, e-mail: shelleymta@aol.com), and an annual seminar is held each May at various locations around the country. Members have access to the MTA library and a computer bulletin board. A monthly newsletter and a periodic MTA Journal are published. Some regional chapters have even been formed. MTA members also become colleagues of the International Federation of Technical Analysts (IFTA).
THE GLOBAL REACH OF TECHNICAL ANALYSIS
During the fall of 1985, a meeting was held in Japan with techni­cal representatives of several different countries to draft a consti­tution for the International Federation of Technical Analysts (IFTA, Post Office Box 1347, New York, NY 10009 USA). Since then, the organization has grown to include technical analysis organizations from more than twenty countries. One of the nice things about being a member is that annual meetings are held in places like Australia, Japan, Paris, and Rome since a different national organization hosts each seminar. I'm proud to say that in 1992 I received the first award ever given at an IFTA conference for "outstanding contribution to global technical analysis."
TECHNICAL ANALYSIS BY ANY NAME
After a century of use in this country (and 300 years in Japan), technical analysis is more popular than ever. Of course, it's not always called technical analysis. In my book, The Visual Investor, I called it visual analysis. That was simply an attempt to get people beyond the intimidating title of technical analysis and to get them to examine this valuable approach more closely. Whatever you want to call it, technical analysis is practiced under many names. A lot of financial organizations employ analysts whose job it is to number-crunch market prices to find stocks or stock groups that are expensive (overbought) or cheap (oversold). They're called quantitative analysts, but the numbers they crunch are often the same ones the technicians are crunching. The financial press has written about a "new" class of trader called "momen­tum" players. These traders move funds out of stocks and stock groups that are showing poor momentum and into those that are showing good momentum. They use a technique called relative strength. Of course, we recognize "momentum" and "relative strength" as technical terms.
Then there are the brokerage firms' "fundamental" upgrades and downgrades. Have you noticed how often these
"fundamental" changes take place the day after a significant "chart" breakout or breakdown? Economists, who certainly don't consider themselves technical analysts, use charts all the time to measure the direction of inflation, interest rates, and all sorts of economic indicators. And they talk about the "trend" of those charts. Even fundamental tools like the price/earnings ratio have a technical side to them. Anytime you introduce price into the equation, you're moving into the realm of technical analysis. Or when security analysts say the dividend yield of the stock market is too low, aren't they saying prices are too high? Isn't that the same thing as saying a market is overbought?
Finally, there are the academics who have reinvented technical analysis under the new name of Behavioral Finance. For years, the academics espoused the Efficient Market Hypothesis to prove that technical analysis simply didn't work. No less an authority than the Federal Reserve Board has thrown some doubt on those ideas.
FEDERAL RESERVE FINALLY APPROVES
During August of 1995, the Federal Reserve Bank of New York published a Staff Report under the title: "Head and Shoulders: Not Just a Flaky Pattern." The report was intended to examine the validity of the head and shoulders pattern in foreign exchange trading. (The first edition of this book was cited as one of the pri­mary sources on technical analysis.) The opening sentence in the introduction reads:
Technical analysis, the prediction of price movements based on past price movements, has been shown to gen­erate statistically significant profits despite its incompat­ibility with most economists' notions of "efficient mar­kets." (Federal Reserve Bank of New York, C.L. Osler and P.H. Kevin Chang, Staff Report No. 4, August 1995.)
A more recent report, published in the fall of 1997 by the Federal Reserve Bank of St. Louis, also addresses the use of tech‑
nical analysis and the relative merits of the Efficient Market
Hypothesis. (Technical Analysis of the Futures Markets was again
cited as a primary source of information on technical analysis.) Under the paragraph titled, "Rethinking the Efficient Markets Hypothesis," the author writes:
The success of technical trading rules shown in the pre­vious section is typical of a number of later studies show­ing that the simple efficient market hypothesis fails in important ways to describe how the foreign exchange market actually functions. While these results did not surprise market practitioners, they have helped persuade economists to examine features of the market ... that might explain the profitability of technical analysis. (Neely)
CONCLUSION
If imitation is the sincerest form of flattery, then market techni­cians should feel very flattered. Technical analysis is practiced under many different names, and often by those who may not realize they're using it. But it is being practiced. Technical analy­sis has also evolved. The introduction of intermarket analysis, for example, has changed the focus away from "single market" analysis to a more interdependent view of the financial markets. The idea that all global markets are linked isn't questioned much anymore either. That's why the universal language of technical analysis makes it especially useful in a world where the financial markets, here and abroad, have become so intertwined. In a world where computer technology and lightning-fast communi­cations require quick responses, the ability to read the market's signals is more crucial than ever. And reading market signals is what technical analysis is all about. Charles Dow introduced technical analysis at the start of the twentieth century. As the twentieth century draws to a close, Mr. Dow would be proud of what he started.

MEASURING MARKET BREADTH
In the previous chapter, we described the top-down approach that is most commonly employed in stock market analysis. With that approach, you begin your analysis with a study of the health of the overall market. Then you work down to market sectors and industry groups. The final step is the study of individual stocks. Your goal is to pick the best stocks in the best groups in an envi­ronment when the stock market is technically healthy. The study of market sectors and individual stocks can be accomplished with the technical tools employed throughout this book—including chart patterns, volume analysis, trendlines, moving averages, oscillators, etc. Those same indicators can also be applied to the major market averages. But there's another class of market indica­tors widely employed in stock market analysis whose purpose is to determine the health of the overall stock market by measuring market breadth. The data used in their construction are advanc­ing versus declining issues, new highs versus new lows, and up volume versus down volume.
SAMPLE DATA
If you check the Stock Market Data Bank section of The Wall Street Journal (Section C, page 2) each day, you'll find the following data for the previous trading day. The numbers shown are based on an actual day's trading results.
The above figures are derived from New York Stock Exchange (NYSE) data. A similar breakdown is also shown for the NASDAQ and the American Stock Exchange. We'll concentrate on the NYSE in this discussion. It just so happens that on that particular day the Dow Jones Industrial Average had gained 12.20 points. So the market was up as measured by the Dow. However, there were more declining stocks (1,559) than advancing stocks (1,327), suggesting that the broader market didn't fare as well as the Dow. There was also more declining volume than advancing volume. Those two sets of figures suggest that market breadth was actually negative for that particular day—even though the Dow itself closed higher. The other figures present a more mixed picture. The number of stocks hitting new 52 week highs (78) was greater than those hitting new lows (43) suggesting a posi­tive market environment. However, the closing tick (the number of stocks that closed on an uptick versus a downtick) was a neg‑
Stock Market Indicators 435
ative, –135. That meant that 135 more stocks closed on a downtick than an uptick, a short term negative factor. The nega­tive closing tick, however, is offset by a closing Arms (Trin) read­ing of .96 which is mildly positive. We'll explain why that is later in the chapter. All of these internal market readings have one intended purpose—to give us a more accurate reading on the health of the overall market that isn't always reflected in the movement of the Dow itself.
COMPARING MARKET AVERAGES
Another way to study the breadth of the market is to compare the performance of the stock averages themselves. Using the same day's trading as an example, the following data lists the relative performance of the major stock averages:
Dow Industrials
+12.20
(+.16%)
S&P 500
54—.64
(—.07%)
Nasdaq Composite
—14.47
(—.92%)
Russell 2000
—3.80
(—.89%)
The first thing that is clear is that the Dow Industrials was the only market average to gain on the day. On all the TV news programs that night, investors were told that the market (repre­sented by the Dow) was up for the day. Yet all the other measures were actually down. Notice also that the broader the average (the more stocks included) the worse it did. Compare the percentage changes. The 30 stock Dow gained .16%. The S&P 500 lost .07%. The Nasdaq Composite, which includes more than 5,000 stocks, was the day's worst performer and lost .92%. Almost as bad as the Nasdaq was the Russell 2000 (–.89%), which is a measure of 2000 small cap stocks. The message in this brief comparison is that even though the Dow gained on the day, the overall market lost ground as measured by the more broader based stock averages. We'll revisit the idea of comparing market averages again. But first, let's show the different ways market technicians can analyze the market's breadth numbers.
THE ADVANCE-DECLINE LINE
This is the best known of the breadth indicators. The construction of the advance decline line is extremely simple. Each day's trading on the New York Stock Exchange produces a certain number of stocks that advanced, a number that declined, and a number that remained unchanged. These figures are reported each day in The
Wall Street journal and Investor's Business Daily, and are used to con‑struct a daily advance-decline (AD) line. The most common way to calculate the AD line is to take the difference between the number of advancing issues and the number of declining issues. If there are more advances than declines, the AD number for that day is posi­tive. If there are more declines than advances, the AD line for that day is negative. That positive or negative daily number is then added to the cumulative AD line. The AD line displays a trend of its own. The idea is to make sure the AD line and the market aver­ages are trending in the same direction.
THE ADVANCE-DECLINE LINE
This is the best known of the breadth indicators. The construction of the advance decline line is extremely simple. Each day's trading on the New York Stock Exchange produces a certain number of stocks that advanced, a number that declined, and a number that remained unchanged. These figures are reported each day in The
Wall Street Journal and Investor's Business Daily, and are used to con‑struct a daily advance-decline (AD) line. The most common way to calculate the AD line is to take the difference between the number of advancing issues and the number of declining issues. If there are more advances than declines, the AD number for that day is posi­tive. If there are more declines than advances, the AD line for that day is negative. That positive or negative daily number is then added to the cumulative AD line. The AD line displays a trend of its own. The idea is to make sure the AD line and the market aver­ages are trending in the same direction. THE ADVANCE-DECLINE LINE
This is the best known of the breadth indicators. The construction of the advance decline line is extremely simple. Each day's trading on the New York Stock Exchange produces a certain number of stocks that advanced, a number that declined, and a number that remained unchanged. These figures are reported each day in The
Wall Street Journal and Investor's Business Daily, and are used to con‑struct a daily advance-decline (AD) line. The most common way to calculate the AD line is to take the difference between the number of advancing issues and the number of declining issues. If there are more advances than declines, the AD number for that day is posi­tive. If there are more declines than advances, the AD line for that day is negative. That positive or negative daily number is then added to the cumulative AD line. The AD line displays a trend of its own. The idea is to make sure the AD line and the market aver­ages are trending in the same direction.
AD DIVERGENCE
What does the advance-decline line measure? The advance-decline line tells us whether or not the broader universe of 3500 NYSE stocks is advancing in line with the most widely followed stock averages, which include only the 30 Dow Industrials or the 500 stocks in the S&P 500. To paraphrase a Wall Street maxim: the advance-decline line tells us if the "troops" are keeping up with the "generals." As long as the AD line is advancing with the Dow Industrials, for example, the breadth or health of the market is good. The danger appears when the AD line begins to diverge from the Dow. In other words, when you have a situation where the Dow Industrials are hitting new highs while the broader market (measured by the AD line) isn't following, technicians begin to worry about "bad market breadth" or an AD divergence. Historically, the AD line peaks out well ahead of the market averages, which is why it's watched so closely.
DAILY VERSUS WEEKLY AD LINES
The daily AD line, which we have described herein, is better used for short to intermediate comparisons with the major stock aver­ages. It is less useful for comparisons going back several years. A weekly advance-decline line measures the number of advancing versus declining stocks for the entire week. Those figures are pub­lished in Barron's each weekend. A weekly advance-decline line is considered more useful for trend comparisons spanning several years. While a negative divergence in the daily AD line may warn of short to intermediate problems in the market, it's necessary to also show a similar divergence in the weekly AD line to confirm that a more serious problem is developing.
VARIATIONS IN AD LINE
Since the number of stocks traded on the NYSE has grown over the years, some market analysts believe the method of subtract‑
ing the number of declining issues from the number of advanc­ing issues gives greater weight to the more recent data. To com­bat that problem, many technicians prefer to use an advance/decline ratio which divides the number of advancing issues by the number of declining issues. Some also believe that there's value in including the number of unchanged issues in the calculation. Whichever way the AD line is calculated, its use is always the same—that is, to measure the direction of the broad­er market and to ensure it's moving in the same direction as the more narrowly constructed, but popular market averages. Advance decline lines can also be constructed for the American Stock Exchange and the Nasdaq Market. Market technicians like to construct overbought/oversold oscillators on the AD lines to help measure short to intermediate term market extremes in the breadth figures themselves. One of the better known examples is the McClellan Oscillator.
McCLELLAN OSCILLATORDeveloped by Sherman McClellan, this oscillator is construct­ed by taking the difference between two exponential moving averages of the daily NYSE advance-decline figures. The McClellan Oscillator is the difference between the 19 day (10% trend) and the 39 day (5% trend) exponential moving averages of the daily net advance decline figures. The oscillator fluctu­ates around a zero line with its upper and lower extremes rang­ing from +100 and –100. A McClellan Oscillator reading above +100 is a signal of an overbought stock market. A reading below –100 is considered an oversold stock market. Crossings above and below the zero line are also interpreted as short to intermediate term buying and selling signals respectively McCLELLAN SUMMATION INDEXThe Summation Index is simply a longer range version of the McClellan Oscillator. The McClellan Summation Index is a cumu­lative sum of each day's positive or negative readings in the McClellan Oscillator. Whereas the McClellan Oscillator is used for short to intermediate trading purposes, the Summation Index provides a longer range view of market breadth and is used to spot major market turning points. NEW HIGHS VERSUS NEW LOWS
In addition to the number of advancing and declining stocks, the financial press also publishes the number of stocks hitting new 52 week highs or new 52 week lows. Here again, these figures are available on a daily and weekly basis. There are two ways to show these figures. One way is to plot the two lines separately. Since the daily values can sometimes be erratic, moving averages (usually 10 days) are plotted to present a smoother picture of the two lines. (See Figure 18.4.) In a strong market, the number of new highs should be much greater than the number of new lows. When the number of new highs start to decline, or the number of new lows start to expand, a caution signal is given. A negative market signal is activated when the moving average of new lows crosses above.
the moving average of new highs. It can also be shown that when­ever the new highs reach an extreme, the market has a topping tendency. Similarly, whenever new lows reach an extreme, the market is near a bottom. Another way to use the new highs versus new lows numbers is to plot the difference between the two lines.
NEW HIGH-NEW LOW INDEXThe advantage of a New High-New Low index is that it can be directly compared to one of the major market averages. In that way, the high-low line can be used just like an advance-decline line. (See Figure 18.5.) The trend of the high-low line can be chart
and it can be used to spot market divergences. A new high in the Dow, for example, that is not matched by a corresponding new high in the high-low line could be a sign of weakness in the broad­er market. Trendline and moving-average analysis can be applied to the line itself. But its major value is in either confirming or diverging from the major stock trends and giving early warning of potential trend changes in the overall market. Dr. Alexander Elder describes the New High-New Low index as "probably the best lead­ing indicator of the stock market" Trading for a Living, (Wiley).
Elder suggests plotting the indicator as a histogram with a horizontal reference point at its zero line, making divergences eas­ier to spot. He points out that crossings above and below the zero line also reflect bullish and bearish shifts in market psychology.
UPSIDE VERSUS DOWNSIDE VOLUME
This is the third and final piece of data that is utilized to mea­sure the breadth of the market. The New York Stock Exchange also provides the level of volume in both the advancing and declining issues. That data is also available the next day in the financial press. It is then possible to compare the upside vol­ume versus the downside volume to measure which is domi­nant at any given time. (See Figure 18.6.) The upside volume and downside volume can be shown as two separate lines (just as we did with the new highs and new lows figures) or the dif­ference can be shown as a single line. Either way, the interpre­tation is always the same. When the upside volume is domi‑ss nant, the market is strong. When downside volume is greater, the market is weak. It's possible to combine the number of advancing and declining issues with advancing and declining volume. That's what Richard Arms did in the creation of the Arms Index.
THE ARMS INDEX
The Arms Index, named after its creator Richard Arms, is a ratio of a ratio. The numerator is the ratio of the number of advancing issues divided by the number of declining issues. The denomina­tor is the advancing volume divided by declining volume. The purpose of the Arms Index is to gauge whether there's more vol­ume in rising or falling stocks. A reading below 1.0 indicates more volume in rising stocks and is positive. A reading above 1.0 reflects more volume in declining issues and is negative. On an intraday basis, a very high Arms Index reading is positive, while a very low reading is negative. The Arms Index, therefore, is a contrary indicator that trends in the opposite direction of the market. It can be used for intraday trading by tracking its direc­tion and for spotting signs of short term market extremes. (See Figure 18.7.)
TRIN VERSUS TICK
The Arms Index (TRIN) can be used in conjunction with the TICK indicator for intraday trading. TICK measures the difference between the number of stocks trading on an uptick versus the number trading on a downtick. The TICK is a minute-by-minute version of the daily advance-decline line and is used for the same purpose. When combining the two during the day, a rising TICK indicator and a falling Arms Index (TRIN) are positive, while a falling TICK indicator and a rising Arms Index (TRIN) are nega­tive. The Arms Index, however, can also be used for longer range analysis.
SMOOTHING THE ARMS INDEX
While the Arms Index is quoted throughout the trading day and has some short term forecasting value, most traders use a 10 day moving average of its values. According to Arms himself, a 10 day average of the Arms Index above 1.20 is considered oversold, while a 10 day Arms value below .70 is overbought, although those numbers may shift depending on the overall trend of the market. Arms expresses a preference for Fibonacci numbers as well. He suggests using a 21 day Arms Index in addition to the 10 day version. He also utilizes 21 day and 55 day moving-average crossovers of the Arms Index to generate good intermediate term
trades. For more in-depth treatment, read The Arms Index (TRIN) by Richard W. Arms, Jr.
OPEN ARMS
In calculating the 10 day Arms Index, each day's closing value is determined using the four inputs and that final value is smoothed with a 10 day moving average. In the "Open" version of the Arms Index, each of the four components in the formula is averaged separately over a period of 10 days. The Open Arms Index is then calculated from those four different averages. Many analysts pre­fer the Open Arms version to the original version. Different mov­ing average lengths, like 21 and 55 days, can also be applied to the Open Arms version. EQUIVOLUME CHARTINGAlthough Arms is best known for creating the Arms Index, he has also pioneered other ways of combining price and volume analy­sis. In doing so, he created an entirely new form of charting called Equivolume. In the traditional bar chart, the day's trading range is shown on the price bar with the volume bar plotted at the bottom of the chart. Since technical analysts combine price and volume analysis, they have to look at both parts of the chart at the same time. On the Equivolume chart, each price bar is shown as a rec­tangle. The height of the rectangle measures the day's trading range. The width of the rectangle is determined by that day's vol­ume. Heavier volume days produce a wider rectangle. Lighter vol­ume days are reflected in a narrower rectangle.As a rule, a bullish price breakout should always be accom­panied by a burst of trading activity. On an Equivolume chart, therefore, a bullish price breakout should be accompanied by a noticeably wider rectangle. Equivolume charting combines price and volume analysis into one chart and makes for much easier comparisons between price and volume. In an uptrend, for exam­ple, up days should see wider rectangles while down days should see narrower rectangles. Equivolume charting can be applied to market averages as well as individual stocks and can be plotted for both daily and weekly charts. For more information, consult Volume Cycles in the Stock Market by Richard Arms (Dow Jones-Irwin, 1983).
CANDLEPOWER
In Chapter 12, Greg Morris explained candlestick charting. In a 1990 article published in Technical Analysis of Stocks and Commodities magazine entitled "East Meets West: CandlePower Charting," Morris proposed combining candlestick charts with Arms' Equivolume charting method. Morris' version shows the candlestick chart in an Equivolume format. In other words, the width of the candlestick is determined by the volume. The greater the volume, the wider the candlestick. Morris called the combi­nation CandlePower charting. Quoting from the article: ". . . the CandlePower chart offers similar if not better information than Equivolume or candlestick charting and is as visually appealing as either of them." Morris' CandlePower technique is available on Metastock charting software (published by Equis International, 3950 S. 700 East, Suite 100, Salt Lake City, UT 84107 [800] 882­3040, www.equis.com). However its name has been changed to Candlevolume.
COMPARING MARKET AVERAGES
At the start of the chapter, we mentioned that another way to gauge market breadth was to compare the different market aver­ages themselves. We're talking here primarily about the Dow Industrials, the S&P 500, the New York Stock Exchange Index, the Nasdaq Composite, and the Russell 2000. Each measures a slight­ly different portion of the market. The Dow and the S&P 500 cap­ture the trends of a relatively small number of large capitalization stocks. The NYSE Composite Index includes all stocks traded on the New York Stock Exchange, and gives a slightly broader per­spective. Breakouts in the Dow Industrials should, as a rule, be confirmed by similar breakouts in both the S&P 500 and the NYSE Composite Index if the breakout is to have staying power.
450 Chapter 18
Most important divergences involve the Nasdaq and the Russell 2000. The Nasdaq Composite has the largest number of stocks (5000). However, since the Nasdaq is a capitalization-weighted index, it is usually dominated by the one hundred largest technology stocks like Intel and Microsoft. Because of that, the Nasdaq is more often a measure of the direction of the tech­nology sector. The Russell 2000 is a truer measure of the smaller stock universe. Both indexes, however, should be trending upward along with the Dow and the S&P 500 if the trend of the market is truly healthy.Relative strength (RS) analysis plays a useful role here. A ratio of the Nasdaq to the S&P 500 tells us whether the technolo­gy stocks are leading or lagging. It's usually better for the market if they're leading and the ratio line is rising. comparison of the Russell 2000 and the S&P 500 tells us whether the "troops" are following the "generals." When the small stocks are showing poor relative strength, or are lagging too far behind the large stocks, that's often a warning that market breadth is weakening.CONCLUSION
Another example of comparing two market averages for signs of confirmation or divergence involves the Dow Theory. In Chapter 2, we discussed the importance of the relationship between the Dow Industrials and the Dow Transports. A Dow Theory buy sig­nal is present when both averages hit new highs. When one diverges from the other, a caution signal is given. It can be seen then that the study of market breadth, and the related issues of confirmation and divergence, can take many forms. The general rule to follow is that the greater the number of stock market aver­ages that are trending in the same direction, the greater the chances are for that trend continuing. In addition, be sure to check the advance-decline line, the new highs-new lows line, and the upside-downside volume lines to make sure that they're also trending in the same direction.