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HAVING TROUBLE PRINTING?
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It's time to round up a couple of old Trader's Corner articles and check on the conclusions achieved in those articles. They discussed charting techniques that attempted to make predictions about a security's movement. It's a good idea to check up later and see if those predictions played out.

This will be an anecdotal, not scientific, glance at some past chart studies. One of those articles discussed exhaustion gaps. If you're not familiar with the term, you might review the article, found at this link.

As mentioned in that article, the third or fourth gap produced during a trending move might be an exhaustion gap. Such gaps, according to market gurus such as Martin J. Pring, can warn that momentum is waning and prices might reverse.

That article combined information about exhaustion gaps with Tom Williams' studies on volume/price-spread analysis. As noted in that previous article, Williams' book, MASTER THE MARKETS, warns that market participants should think differently about volume than they're accustomed to doing. They should combine observations about volume with observations about what happened as a result of that volume.

For example, the common wisdom is that market participants need to see confirming strong volume when a new high is reached and confirming strong volume when a new low is reached. Williams would warn that, important as that information is, it leaves out half the important information. If there was a high-volume breakout to the upside, for example, but prices pulled back strongly by the end of the day, leaving a long upper candle shadow behind, what did that mean?

Williams argues that the high volume means that big money was involved, and the pullback likely means that big money was distributing and not accumulating. Conversely, a new recent low on high volume pierces a new level but bounces by the end of a high-volume day, leaving a long lower shadow, would suggest that big money was involved and accumulating.

It's not all as easy as that, of course. All kinds of caveats and tests apply, so I urge a review of that article if you haven't read it. In fact, I urge a review of Williams' book if you can find it. It's a costly book with poor production values but plenty of information, but I've heard that it's sometimes found as a downloadable on the Internet. I paid full price, of course, buying it just before I started hearing about those promotional copies.

In my previous article, I combined an observation of a possible exhaustion gap with a look at volume and price spread when it was created. One example employed was found on a chart of ARRS. Below you'll find the original chart included in that article.

Annotated Daily Chart of ARRS:

Although I had clarified that the chart wasn't being offered as a trade suggestion, the conclusions reached as a result of the possible exhaustion gap and the big volume presented the possibility that "[a]s of February 15, then, it looked possible that an exhaustion gap was forming that might signal at least a short-term turning point for ARRS." I listed some concerns about whether a turnaround would be immediate and also the dangers of a rollover again from gap resistance at the top, midpoint or bottom of that gap.

Now it's time to see what's happened since.

Annotated Daily Chart of ARRS, as of April 24:

Another article, published in the December 15, 2007 edition of the Option Investor Newsletter, was itself a follow up to a November 24 article discussing the corrective fan principle as described by Pring. Those who aren't familiar with the corrective fan principle might review the previous article at this link.

The corrective fan principle, as applied to a downtrend, suggests that the first sharp decline creates a steep descending trendline. It's too steep to be maintained. Prices break up through that trendline and some equity bulls celebrate, thinking that the downtrend has concluded.

Instead, a second, less steeply declining trendline is forming. Its slope is not as severe, but the trendline is probably still too steep to be sustainable. Prices break up again through this second trendline and bulls celebrate again, thinking the downtrend over. By that time, significant damage can have been done. However, it's not until the third trendline is formed and then subsequently broken that the downtrend is completed. Price movements might become disorganized for a while or might begin a new uptrend.

Sometimes those trendlines are easy to discern, particularly if RSI forms trendlines of its own that are broken at the same time or previously to the price trendline breaks. However, as of the time of that December 15 article, it wasn't so easy to determine where the trendlines defining the corrective fan lay. Markets had just seen a steep rally off the November low, but since a third trendline hadn't yet fully formed, much less been broken, the corrective fan principle suggested that the downtrend had not yet concluded. The chart below is a chart included in that December 15 article.

Annotated Daily Chart of the SPX:

The conclusion at the end of that article was that subscribers "should consider the possibility that the last month's sharp rally was nothing more than a relief rally up to the second of three descending trendlines or fanlines that will eventually form."

What's happened since? Clearly, the downtrend had not concluded and that sharp November rally was indeed nothing more than a relief rally. Time and again, follow up articles on the correct fan principle have shown it to be worthy of study when trying to determine whether a trending move has ended.

What about the location of the second and third trendlines? Have those trendlines since been clarified?

Annotated Daily Chart of the SPX as of April 24, 2007:

If not for the following price movements, I would have totally discounted the validity of that blue trendline: the action seen in late February, when prices rose to test that blue trendline and pulled back; in late March when prices did so again before breaking through; and April 14 and 15, when prices dipped to the trendline and then sprang higher again. Those actions do keep it in the running for the location of the second in the three trendlines.

I'm not totally convinced that it's a valid second trendline. The price movements since that trendline was first drawn do not appear typical of those I've seen in the many times over many years that I've observed the corrective fan principle at work. It's not usual to see prices break back below the second trendline and spend so much time below it after first breaking through it and beginning the formation of the the third trendline. I suspect the green trendline may in fact be the second trendline with a third one yet to go.

But I don't know that for sure. This case has me stumped. So, here's what we know for sure. At least two trendlines have been or may be in the process of being established. The green trendline as drawn still has only two touchpoints, so may not be in the final form. If the green line were drawn through the upper candle shadow on December 11's high, cutting off that shadow, the April 14 high was a third touch point for the green trendline, so it's possible that we'll decide that version works best at some point in the future. Or prices may rise up to test the version drawn above and pull back from that, validating that version.

Whether the green trendline is the second or third corrective fanline, as of April 24 it had not been violated to the upside, no matter how it was drawn. The best-fit version would have been pierced on both December 11 and April 24, but both days, the closes were at or below the trendline. As of April 24, then, whether that green trendline is the third fanline or not, the corrective fan principle says that the downtrend that began last fall has not yet concluded.

We're going to have to check on this one again. Another decline to and bounce from the blue trendline would force me to give it credence as the second trendline of the three corrective fanlines. Those hoping for an end to the downtrend would then want to see an upside break of the green trendline. They should prepare for the possibility that what happens next is a period of disorganization rather than a new uptrend. A new trend doesn't always occur immediately.

If prices instead break immediately up through the green trendline while we're still undecided about whether its the second or third corrective fanline, as they threatened to do April 24, some question remains as to whether that's the final break, the end to this particular trend, or not.

I've drawn and redrawn these trendlines. I've fanned them out from the 10/31/07 high rather than the 10/11/07 higher high, thinking that perhaps this downtrend really began with that lower 10/31 high. I've tried this and that, and I'm stumped, but my best guess at this time is that the green trendline may well be only the second and not the third of the three corrective fanlines.
 

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