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The Corrective Fan Principle

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After Callaway Golf (ELY) retested its October 2002 low in October 2004, investors must have been delighted to see the stock begin a bounce. That bounce eventually took the stock from its October 2004 low of $9.28 to a high of $17.40 reached in April of this year, almost a double. The stock's price then dropped through an ascending trendline off that October 2004 low and was trading at $12.99 as this article was prepared on July 2. Has the rally off that 2004 low ended?

Annotated Weekly Semi-Log Chart of ELY:

No averages are shown on this chart, but the downtrend since April has driven ELY's price sharply below its 200-sma, clearly a negative for investors. However, while the short-term trend remains down, the corrective fan principle suggests that prices could attempt a rise to retest this broken trendline. The longer-term rally may not quite have ended, although that corrective fan principle suggests that it may be on its third and last leg. Let's look at the principle and how it relates to ELY's move.

Martin Pring elucidated the corrective fan principle in his book, TECHNICAL ANALYSIS EXPLAINED. The first point of this principle can be illustrated by a closer look at ELY's initial rally off that October 2004 low.

Annotated Weekly Semi-Log Chart of ELY:

Such an explosive move is often characteristic as the last low or bottom is established and a rally begins. Such explosiveness is also typical of the first drop after a top has been established and a new decline begins. The explosiveness of those first moves off a bottom of a top can not be sustained, Pring explains, and that first trendline will then be broken and a more gradually rising or descending trendline established.

ELY's prices rose to retest that first too-sharply-rising trendline in mid-2005 but fell back without even touching the trendline. Some would have considered that a bearish sign, and it certainly was over the summer of 2005, but those who discounted the rally off the 2004 low were mistaken. ELY rose again in early 2006, establishing a higher high than any reached in 2005. While it was doing so, it established that second rising trendline, the red one, off that October 4 low.

According to the corrective fan principle, the second rising trendline is also too steep to sustain over an extended period, and prices may need to establish a third rising trendline with an even more gradual slope.

Annotated Weekly Semi-Log Chart of ELY:

Most technicians believe that it takes three points of contact to establish a trendline, not two, so ELY has not yet established that third trendline.

These three trendlines discussed in this article can also be called fan lines, since they fan out from the original low (or high, in the case a decline). Pring explains that the rally would be considered finished when prices broke through the third rising trendline or fan line. Similarly, a decline would have completed when prices broke up through a third descending trendline.

The fan lines can be open to interpretation, of course, and require some art and knowledgeable guesswork. Perhaps another technical analyst might find three fan lines already laid out on ELY's chart, with the third already violated.

However, many traders are surprised when prices violate a rising trendline, then soon bounce and climb the underside of that trendline into a new high. They might not be so surprised and so quick to assume a rally was finished if they kept the corrective fan principle in mind.

Traders who jumped into a bearish play on ELY when that first explosive move was exhausted and ELY violated the first fan line were rewarded since its drop was deep, but that isn't always true. That first fan line violation sometimes results in only a minimal move before another rally.

Annotation 240-Minute Chart of GM:

Note that GM's chart also is not the current one, but one annotated on July 2, when this article was first prepared.

The corrective fan principle can be utilized when studying charts across any time frame, although the longer the time frame, the more reliable the information. Be sure to switch to semi-log charts if you're studying movements that occur across many months. In addition, the principle can be used to watch both rallies and declines. Declines, in particular, often demonstrate explosive first moves.

Pring cautions that the break of the third trend or fan line often suggests a change in trend.

Annotated 120-Minute Chart of FDX:

Notice how well FDX's decline fit the corrective fan principle. The first drop was precipitous. A break of the first fan line did not signal that the down trend had been completed. In fact, FDX's prices were to drop lower than the May low. However, that first fan line descended too steeply for that movement to be sustained. A new and more sustainable trend or fan line was established. When it was broken, a third was established, but it was to be sustained only a short while before FDX was to break through that fan line again.

As FDX's chart demonstrates, trading a rally or a decline when a third trend or fan line is being established can be a dangerous endeavor. Those who might be long ELY, the rally example that may be currently establishing that third fan line or trendline, should remain cautious about long positions. Although prices that are bouncing up from or back from a third trendline or fan line can still hit a new high in the case of a rally or a new low in the case of a decline, the establishment of a third trendline marks the time to start planning protective measures if that hasn't already been done.
 

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