Option Investor
Trader's Corner

More of This and That

Printer friendly version

Last week's Trader's Corner followed up on a previous article, and I thought that trend might be a good trend to continue. When I write novels, I like to tidy up all the loose ends, and I feel that I should do the same when writing these articles.

One of those loose ends was first introduced in a Trader's Corner article back on March 20. The article theorized that it was useful for those trading the Dow, SPX and OEX to study the NYSE advance/decline line using standard technical analysis tools. The article pointed out that this study should be accomplished on intraday charts as the daily ones provided little information. The following daily chart illustrated the conclusion that, because the A/D line could move only so far in any one direction, the daily chart provided little useful information. However, something on the chart I'd used as an example piqued my interest, as the annotations on the original chart show.

Annotated Daily Chart of the A/D Line as of Mid-March:

That intriguing contraction and expansion of the A/D line on the daily chart continued to intrigue me. Although a cursory look at the chart suggested some sort of sound wave and nothing to help us with our trading, could the contraction and expansion produce signals? Had that same contraction and then expansion accompanied the recent downturn in the markets?

Annotated Daily Chart of the A/D Line as of 7/07/08:

Hmm. More and more intriguing, isn't it? Such a tendency could also make sense from a logical point of view, if big trending moves are born out of a period of consolidation. Consolidation is a period when bulls and bears are rather evenly matched, when neither can win the day. Whether or not volume contracts or expands, the even matching of the bulls and bears would mean that the swings in the A/D line would tamp down.

Questions immediately arise. Would a rally born out of a consolidation period show the same pattern? Would the contraction or the breakouts occur in a different manner? Are the triangles sometimes not neutral triangles but sometimes bullish or bearish ones with flat tops or bottoms?

Obviously, those questions can't be answered by a cursory look at a few charts. Also obviously, someone else has probably studied this in depth, although I haven't found the studies yet. However, to further explore these questions in an anecdotal way, I scrolled back through the SPX's daily chart, without looking first at the A/D chart, until I noticed the rally off the October 2005 low. Only then did I look at the A/D chart. I hadn't wanted to cherry pick a point in which I could already see a contraction in the A/D line.

Annotated Daily Chart of the SPX:

Annotated Chart of the A/D Line in late 2005:

On 12/14 and 12/15 of that year, the SPX was hitting a lower high and began a consolidation period that would eventually carve out a broadening formation, an unusual formation that's not always seen at the top of a climb. Such formations are typically emotion-based and are considered potentially bearish formations, although this one broke to the upside. A glance at the A/D chart above shows us that the A/D line was actually broadening during the formation of that broadening formation, as might be expected if it was an emotion-based formation.

While breakouts might attend the end of a consolidation period, that action during the broadening formation proves that not all consolidation or reversal formations produce a narrowing A/D line pattern. A broadening formation did not.

Neither does the A/D line always narrow into a triangle. The period from 5/17/07 to 9/06/07 was characterized by a rising channel on the A/D line. On 5/17/07, the SPX began chopping out an inverse or reverse head and shoulders.

Annotated Daily Chart of the SPX:

What's the conclusion to all these charts and suppositions? The conclusion should be that perhaps those sound waves on the daily A/D chart do mean something after all. Perhaps we should watch for a narrowing and then a breakout of that narrowing as confirmation that a new trend has begun. Perhaps we should watch the shape of any triangles or rising channels or broadening formations on the A/D line for clues as to what's happening with the markets, too.

But does it mean something in particular if the break out of a narrowing triangle is first to the downside or first to the upside? The initial studies suggest that both rallies and declines can begin with a break to the downside, so it seems to matter more that the narrowing formation is violated on a daily close than that it break one direction or another, at least on first glance. Does it mean anything if the topside is flat and the bottom rising, or vice versa? It's easy to notice the breakdown out of a narrowing formation, but what about the beginning of a rising channel? It's not so easy to identify those until a number of touches have occurred and trendlines can be established.

Unfortunately, the few charts available here provide enough information to intrigue traders and pose further questions but not enough information to warrant too strong a belief in the predictive power of any one pattern on the daily A/D chart. They intrigue me enough that I'll keep watching, however, and I'll certainly pay attention if I see a narrowing formation set up, watching for the breakout.

Trader's Corner Archives