Classical Chart Analysis

Jun 9, 2020
11 min read

Updated: Jul 3, 2020

Disclaimer: content is summarised from Part 3 (Chapter 17 - 20) of 'The New Trading for a Living: Psychology, Discipline, Trading Tools and Systems, Risk Control, Trade Management' by Alexander Elder

1. Charting

Key concepts of classical charting remain valid, though many of its tools have been eclipsed by much more powerful computerised methods. Classical charting, unlike computerised technical analysis, is quite subjective. It invites wishful thinking & self-deception.

Most traders work with bar / candlestick graphs that show open, high, low, closing prices & volume. The biggest problem with classical charting is wishful thinking. Traders seem to identify bullish / bearish patterns, based on whether they're in the mood to buy / sell.

TSLA daily. (Chart by Stockcharts.com)

The Meaning of a Bar Chart (daily bar)

Chart patterns reflect the sum of buying & selling, greed & fear. Each price is a momentary consensus of value of all market participants expressed in action.

Opening & Closing Price

Opening price reflects the amateur’s opinion of value. Amateurs are active early in the day & week. Activity of amateurs early in the day creates an extreme from which prices tend to recoil later. Bull market prices often make their low for the week on Monday / Tuesday, when amateurs take profits from the previous week, then rally to a new high on Thursday / Friday. Bear market highs for the week are often set on Monday / Tuesday, with a new low toward the end of the week. Closing price reflects actions of professional traders as they dominate the last hour of trading. Many take profits at the last hour to avoid carrying trades overnight.

Pay attention to the relationship between opening & closing prices. If prices close higher than they opened, pros were probably more bullish than amateurs. If prices close lower than they opened, pros were probably more bearish than amateurs. Candlestick charting is based largely on the relationship between opening & closing prices of each bar.

Bars

High of each bar represents the maximum power of bulls during that bar, whilst low of each bar represents the maximum power of bears during that bar. A maximum is reached as capital / enthusiasm runs out. Closing price of each bar reveals the outcome of the battle between bulls & bears during that bar. Distance between high & low of bar shows the intensity of conflict between bulls & bears. Slippage tends to be less in quiet markets hence, it pays to enter trades during short or normal bars.

Japanese Candlesticks

Body of each candle represents distance between the opening & closing prices. If closing price > opening price, body is white, if closing price < opening, body is black. Tip of upper wick shows the high of the day, while bottom of the lower wick shows the low of the day. Main advantage of a candlestick is the focus on the struggle between amateurs who control openings & professionals who control closings. However, many candlestick chartists neglect Western tools like volume & technical indicators. Combination of both would provide more information.

Efficient Markets, Random Walk & Chaos Theory

Efficient Markets theory has the notion that nobody can outperform the market as any price at any given moment incorporates all available information. However, though people may have knowledge, emotional pull of the crowd often leads them to trade irrationally. Good analysts detect repetitive patterns of crowd behaviour & exploit them.

“Random Walk” suggests that market prices change at random. However, there is repetitive behaviour. E.g. Memories help create support under the market &resistance above it (S&R will be explored further down)

“Chaos Theory“ suggests that markets are largely chaotic, & the only time you can have an edge is during orderly periods. Essence of market analysis is recognising emergence of orderly patterns & having enough courage and conviction to trade them. This also suggests that one should only trade when best to, unlike professionals who have to continually trade. This is less detached from reality compared to the other theories.

2. Support & Resistance

S&R acts as floor & ceiling with prices sandwiched between them. Strength of S&R diagnoses if trends are to punch through (prevail) / reverse. Support is a price level where strength of buying interrupts / reverses a downtrend (buyers > sellers). Hence, when a downtrend hits support, it bounces up. It is represented on a chart by a horizontal line connecting 2 or more bottoms.

Resistance is a price level where strength of selling interrupts / reverses an uptrend (buyers < sellers) It is the opposite of support.

NFLX weekly. (Chart by Stockcharts.com)

- After a decisive upside breakout at (1), resistance turns into support (initial ceiling becomes a new floor due to uptrend). Strength of these barriers increases each time prices touch them & bounce away. Beware of false breakouts of S&R (F). Draw S&R lines across edges of congestion areas where bulk of the bars stopped. Congestion zones show where the masses have changed their minds, while the extreme points only reflects panic among weakest traders. Minor S&Rs pause trends, major S&Rs reverse trends. Traders buy at support & sell at resistance. However, computerised technical analysis like EMAs can spot trends better.

Memories, Pain, & Regret

Memories of previous market reversals causes us to buy / sell, creating S&R lines. If traders remember that prices recently stopped falling & turned up from a certain level, they are likely to buy when prices approach that level again. We have the tendency to hope that history would repeat itself.

Gold weekly. (Chart by Stockcharts.com)

Usually reversals occur on the 1st, 2nd or 3rd hit. With the diagram showing a 4th hit, it shows that the market really wants to move in that direction. 2 failed attempts to move down to its old R level in (6) & (7) shows that bears were weak, marking the start of a major bull market in gold.

S&R exists because masses of traders feel pain & regret. These feelings of pain & regret are mild in ranges when swings are small, but breakouts from those ranges creates much more intense feelings. When the market stays flat for a while, traders get used to buying near the lower edge of its range & selling near the upper edge. E.g. of how support is created: with an uptrend, bears who sold short feel pain & bulls that did not buy more feel regret. Both are determined to buy if market declines to the same breakout point.

Strength of Support & Resistance

The longer prices stay in a congestion zone, the stronger the emotional commitment of bulls & bears to that area. Strength of zones depends on: length, height & volume of trading (length, width & depth of zone). 2-week trading range provides minimal S&R, 2-month range creates intermediate S&R, while a 2-year range offers major S&R. However, S&R levels that grow very old weaken as losers wash out & are replaced by newcomers that do not have the same emotional commitment to old price levels.

If congestion zone's height = 1% of current market value (CMV), it provides only minor S&R. 3% tall provides intermediate S&R. ≥ 7% tall can grind down a major trend. As volume of a zone increases, active involvement increases hence stronger emotional commitment thus zone gets stronger.

Trading Rules

A protective stop is an order to sell below the market when longing / cover shorting so as to cut losses from reversals. Hence, tighten your protective stop when trends approach S/R. If trend is strong enough to penetrate that zone, tight stop will not be triggered. If a trend bounces away from support or resistance, it reveals its weakness. In that case, your tight stop will salvage a good chunk of profits.

S&R is more important on long-term charts than short-term. Assign more weight to longer timeframes. It is more alarming that weekly trends approach major S&R as opposed to that of daily trends. When that happens, be more inclined to exit.

S&R levels provide trading opportunities. As prices dip below S zone & goes back up it marks a buying opportunity; set a protective stop in the vicinity of the bottom of the most recent false downside breakout. A true upside breakout should not be followed by a pullback into the range (like how a rocket is not supposed to sink back to its launching pad). False upside breakouts give a signal to sell short as a price bar returns into the congestion zone. When shorting, place a protective stop near the top of the false breakout.

When placing stops, avoid placing at round numbers. Human tendency to use round numbers causes clusters of stops accumulate there. E.g. if you want to protect your position at $33.50, put the stop a few cents below $33.50.

True & False Breakouts

Markets are more often in trading ranges than trends. Most breakouts from ranges are false breakouts. FBs attract trend-followers only to return to ranges which hurts amateurs.

However, pros wait til an upside breakout stops reaching new highs / a downside breakout stops making new lows. They then trade against it the false breakout & place a protective stop near the latest extreme point. Monetary risk is low, with huge profit potential from prices returning to middle of range. Risk/reward ratio is so good that pros can afford to be wrong half the time & come out ahead of the game.

The best time to buy an upside breakout on daily chart is when weekly chart suggests a new uptrend is growing. True breakouts are confirmed by heavy volume, while FBs tend to have light volume.

EGO and the Euro daily. (Chart by Stockcharts.com)

Eldorado Gold Corp chart shows a false downside breakout during gold bears’ final attempt to push gold stocks lower in Dec 2013. Prices opened sharply below S line before a rally began. Notice a pullback at the green arrow. Such pullbacks do not always occur, but when offers an opportunity to hop aboard a new trend.

Euro chart shows how an uptrend culminated in a false upside breakout. Prices gapped above R line, triggering stops & shaking out weak shorts. Downtrend begins and there was no pullback after that.

3. Trends & Trading Ranges

Trends occur if prices keep rising / falling over a period of time. A perfect uptrend occurs when each rally reaches a higher high than before & each decline stops at a higher level than before. In a trading range, most rallies stop at about the same high level, and declines stop at about the same low level. Perfect patterns are uncommon & multiple deviations (retracements) make life harder for analysts.

Trading ranges call for tighter stops to close out positions at the slightest sign of reversal. Wider stops are used for trends. Handling of strength & weakness differs too. E.g. follow strength during trends—buy in uptrends & short in downtrends. When prices are in a trading range, do the opposite—buy weakness & sell strength.

FB daily, 22-day EMA. (Chart by Stockcharts.com)

Downtrend of Facebook seen with lower lows of (1)(3)(5) & lower highs of (2)(4). Notice the downtrend of a slow 22-day EMA which confirms downtrend (red line). Upside reversal is confirmed by new price peaks (6)(8). 2 false upside breakouts with decreasing EMA gives a sell signal.

Mass Psychology

In a downtrend, bears are more aggressive & their selling pushes markets down. In the trading range, bulls & bears are equal in strength. When bulls manage to push prices up, bears sell short into that rally & prices fall. As prices decline, bargain hunters step in to buy. Bears cover shorts by buying which helps fuel a rally. This cycle can go on for a long time.

A trading range is like a fight between 2 equally strong gangs. They push back & forth, but neither can control the city block. Crowds spend most of their time aimlessly milling around, hence markets spend more time in trading ranges. A crowd has to become agitated & surge to create a trend. Crowds do not stay excited for long & go back to aimlessness.

The Hard Right Edge

By the time a trend becomes perfectly clear, a good chunk is already gone. Many chart patterns & indicator signals contradict each other at the right edge of the chart. You have to base your decisions on probabilities. Pros get out of losing trades fast. When the market deviates from analysis, cut losses without fuss.

Methods & Techniques

Combine several analytic tools. When they confirm each other, a correct message is much more likely. When they contradict, pass up a trade. Below, we see an example of combining tools to confirm trends.

UNP daily, 22-day EMA, Directional system, MACD-Histogram. (Chart by Stockcharts.com)

Most important identifier of any trend is pattern of highs & lows. In the daily chart of Union Pacific Corp (UNP), once out of its trading range, its highs reached higher levels & lows were at higher levels (horizontal green & red lines). 22-day EMA (red line imposed on prices) confirms uptrend with its steady rise. Notice buying opportunities at quick price dips to their MA.

Directional system signals start of a new trend when the Average Directional Index (ADX) fell below 20 & rallied above that level & penetrated above the lower Directional Line (vertical green arrow). MACDHistogram identified a powerful trend when it rallied to its highest peak in several months (diagonal green arrow). Near the right edge, the trend is up, while prices are slightly below their recent high. Pullback to EMA is likely to create a buying opportunity.

Steps:

1. Analyse pattern of highs & lows. E.g. Higher highs + higher lows = uptrend

2. Plot a 20 - 30 bar EMA. Direction of slope identifies trend. If EMA has not reached a new high / new low in a month, market is probably in a trading range

3. When an oscillator, like MACD-Histogram rises to a new peak it identifies a powerful trend & suggests that the latest market top is likely to be retested / exceeded

4. Market indicators, like Directional system identifies trends & is especially good at catching early stages of new trends

Trade or Wait

Buying fast means catching trends early but stops are further away, thus risk is higher. Waiting mitigates risk but you will compete with longers who want to add to their position, shooters who want to get out even, traders like you who waited, shooters who sold too early, but are eager to buy. Waiting areas for pullbacks are notoriously crowded. Deep pullbacks may signal beginning of a reversal.

When waiting for a breakout, either: buy pre breakout, during breakout / on a pullback after a valid breakout. If unsure ⅓ of quantity each. Key risk management rule: never risk more than 2% of your account equity. Trading ranges are harder to find entry points than trends. Trends: smaller position, bigger stop. Trading Range: bigger position, smaller stop.

Conflicting Timeframes

Markets move in several timeframes at the same times. Indicator signals in different timeframes may contradict. Before examining a trend, explore charts in a timeframe 1 order of magnitude greater than your favourite. Look at the big picture when in doubt.

4. Kangaroo Tails

A Kangaroo Tail is a single very tall bar, flanked by 2 regular bars, that protrudes. Upward-pointing KTs provide sell signals at market tops (opposite for downward). The longer the timeframe, the more meaningful its signal. KTs are reliable & easy to recognise.

BIIB and FDO daily. (Chart by Stockcharts.com)

Biogen Idec, Inc (BIIB) was steadily rising til a KT developed. Stock opened slightly below its previous close then it traced a very tall bar, 3x the average height. It reached a record new high but then slid, closing near its opening price. The next day’s bar was of average height—it completed the kangaroo pattern & the trend reversed down.

If a rally / selling attracts no orders, the market will reverse & look for orders at lower / higher levels. KTs reflect failed bull / bear raids. When markets recoil from KTs trading opportunities are offered. They show a certain price rejected by the market that usually leads to a swing in the opposite direction. Trade against a KT once you see it. Experienced traders recognise KTs during its 3rd bar, before it closes.

IGT Daily. (Chart by Stockcharts.com)

KTs mark the final splash of bullishness / bearishness. KT ( red arrow) identifies end of an uptrend in International Game Technology (IGT) stock. If entering a short trade during the 3rd bar, place your stop about half-way up the tail. A stop at the tip of the tail is too risky. KT (green arrow) stopped downtrend & augured in a week-long rally

Trading against KTs is a short-term tactic; on the daily charts, these signals fizzle out after a few days. Putting a stop at end of a tail risks too much capital. When trading against KTs, place protective stop about halfway through the tail. If the market starts “chewing its tail, get out.