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Turning the Abstract into the Concrete

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Two women study three white rectangles outlined in black against a white background. The title is "Deliberation". The first woman tilts her head head. "What does it mean?" she asks.

Raising one eyebrow, rubbing a forefinger under her chin, the second woman intones, "It means something different to each person."

Not exactly. The three rectangles have a specific meaning. The women aren't visiting an art gallery featuring abstract art, but rather are looking at a candlestick formation. Deliberation serves as a moderately reliable bearish reversal signal.

Annotated Daily Chart for LEA:

After completing the deliberation pattern, LEA would tumble all the way to sub-$50.00 levels before reversing upward again. Despite the abstract name, the pattern revealed concrete proof of waning buying interest. The gap higher proved to be an exhaustion gap. The upper and lower shadows uncovered the bulls vs. bears battle, and hinted that bulls would not win the battle.

Go beyond the abstract name. Do more than memorize chart patterns. Although the names may sound like mumbo jumbo, the patterns aren't abstract. The messages about buying and selling interest can be understood.

They should be understood. Breaking down chart patterns or formulas used in technical analysis helps traders use these tools more effectively. To see how a trader might gain a deeper understanding of a pattern, technical analysis tool, or formula, consider pivot points. In a recent Traders Corner article, Jane Fox discussed pivot points, providing formulas used for their calculations. Building on the information that Jane provided, readers might delve further. Here is the formula for the pivot:

Pivot point = P = (H L C)/3

What does that formula mean? It's an average of the high, low, and close. How would that average change as prices move? What happens to that average on an up day when prices close near the high of the day? What about on a down day when prices closer near the low of the day?

If price closes nearer the high of the day, that average or pivot point will be above the midpoint of the previous day's range, in the more bullish half of that day's range. If price closes nearer the low of the day, that average is going to be below the midpoint of the previous days range. A series of strong day's results in pivots marching higher, and a series of weak days results in pivot points stepping lower.

Let's run some numbers. If MYTH, a hypothetical stock, traded a high of 24 and a low of 18, and closed at 22, the midpoint of the day's range would be 21. Would the pivot point be above or below that midpoint, in the bullish or bearish half of the day's range? The pivot point calculation (Case 1) would be as follows:

Pivot Point = P = (24 18 22)/3 = 21.33. This is above 21, the midpoint of the day's range.

If MYTH, our hypothetical stock, traded a high of 24, a low of 18, and closed at 18, the pivot point calculation (Case 2) would be as follows:

Pivot Point = P = (24 18 18)/3 = 20. This is below the midpoint of the day's range.

In both cases, the pivot point is above the close of the previous day. Is this always true? What would need to happen for the close to be above the pivot? Let's do some elementary algebra and figure it out. Imagine a case in which the previous day's close was above the pivot, say one point above the pivot.

P = C-1 = (H L C)/3
3(C-1) = H L C
3C 3 = H L C
2C 3 = H L

So we have three variables here, but let's still substitute a value for the close and see what we find. Imagine that the close was at 20.

2(20) 3 = H L
37 = H L

Is it possible for the high and low to equal 37 when the close was 20? Sure it is. The high could have been 22 and the low 15, for example. We can't assume that because the first two cases produced pivot points above the close that they'll always be above the close, so maybe that adds one bit of knowledge to our understanding of how pivots work.

How do the first two cases discussed above affect the support or resistance levels? The formula for S1 is as follows:

First level of support = S1 = 2P H.

Remember that P is an average of the high, low and close. The closer this average is to the high of the day, the nearer the first level of support the next day is going to the high of the day preceding it. Previous calculations showed us that P is nearer the high when the close was nearer the high, on days when prices are showing strength. That seems intuitive and it is, but tinkering with the numbers confirms our intuitions.

In what cases will support and resistance levels bunch up? In what cases will they spread wide? Although it appears contrary to logic, is it ever possible for S1 to be above the close? Could that first support level ever be right at the high of the day used for the calculations? Run through sample numbers to find out. For example, an examination of the formula shows that the only way S1 could ever equal the high of the previous day is if prices spent all day at the opening level, never moving. Elementary algebra returns this conclusion. If the S1 is to equal the high of the day, then the formula reads as follows:

S1 = H = 2P H
Solving for P:
2H = 2P
H = P

If H must equal P in order for the S1 to be at the high of the day, then go back to the formula for the pivot and substitute H for P:

Pivot = P = H = (H L C)/3
H = (H L C)/3
3H = H L C
2H = L C

Tinkering with that last formula shows that if the low is any value lower than the high of the day, the close must be higher than the high of the day, an impossibility. For example, imagine that the low is 1 point below the high. Here is how that last formula above would work out, with (H-1) substituted for the low:

2H = (H 1) C
Solving for C:
H 1 = C

That says that the close is 1 point above the high of the day. Can't happen. No value returns a valid solution. The only way S1 can be at the high of the day is if the low and the high are equal.

What about resistance levels? The formula for R1 is 2P L. What will happen to this number in cases when MYTH closes nearer the high of the day? Since the pivot rises as MYTH closes nearer the high of the day, one might reason that the R1 will move higher. Calculations will show that to be true.

I know what you're thinking. Some charting services offer click-on-the-chart pivot analysis support and resistance points. If yours doesn't, a spreadsheet will. Perhaps you can't think of a single reason that you'd ever want to know whether S1 was likely to end at or near the high of the previous day and the conditions needed to make that happen. However, if you want an instinctive knowledge of what the formulas mean and how they work under differing market conditions, if you're making hold-over-or-not decisions on the fly at the end of the day, nothing beats an hour or two making calculations or even running different number combinations through your spreadsheet so that you intuitively understand these matters.

Does this help? Sure it does. Try it with other technical analysis tools.

Hand chart some of those X's and O's in point-and-figure charting. You'll gain a better knowledge of what this charting method is showing about supply or demand. Combine the candlesticks in a multi-candle-pattern and you might understand the pattern's implications better. Combining the three candles of an evening-star pattern results in a gravestone doji, for example, leaving a long upper shadow and either no real body or a small real body at the bottom of the candlestick. Suddenly, that three-candlestick pattern looks clear in its implications. Prices pierced resistance, but were met with strong selling and rebuffed.

Not mumbo jumbo after all, is it?
 

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