In my last (4/29) Trader's Corner, part of an ongoing series of fundamental articles on technical analysis, I went into what I've found to be the most effective use of trendlines to see where trends reverse. This 2nd in my article series can be reviewed by clicking HERE.

One purpose I have with this article series is to get them into our Trader's Corner archive. Once there I can LINK to an explanatory piece on some aspect of market analysis. Those who want the further explanation then can go to it. Those that don't won't have to wade through explanatory material.

From trendline construction, I will move into the construction of parallel price channels. First I have a couple of odds and ends from my mailbag and one personal aside.

RECENT MARKET MELTDOWN:

It turns out that there is a mismatch between NYSE's 'circuit breakers' and the electronic exchanges that have gained a lot of the total daily trading volume. The mismatch is that the NYSE has such mechanisms versus NONE for the other exchanges (including Nasdaq). Regulations certainly lag technological changes and trends! There is now talk of mandating circuit breaker mechanisms for ALL the exchanges. Circuit breaker creation goes back to black Monday in '87 and the market meltdown caused by shorting stock index futures on large declines in order to create so-called 'portfolio insurance'.

MAILBAG:

"It seems from what you were writing about making trendlines that there wouldn't be an end to it. you would keep redrawing them as prices went lower. Is this useful and isn't it sort of an endless process?"

MY RESPONSE:

Not an infinite process. There is a point, usually after 1-2 times of re-drawing trendlines as prices decline (our most recent example), where there is a 'final' trendline that get pierced. Especially in cases of an overbought market, such breaks can precede a major break like we had last week. I can provide a couple of recent examples in the indexes: a somewhat more complex example with the Dow 30 (INDU) chart and a simpler example (of redrawing trendlines) with the Nasdaq 100 (NDX) Index.

The first trendline seen below connecting 2-3 or more points (the more the better), Trendline 1 (T1) on the INDU daily chart is seen below. With the slowing upside momentum of early-April, the next 'best fit' internal trendline (line connecting the most number of lows) is seen at T2. The rally then stalled in the area of the trendline and a few subsequent lows formed Trendline 3. That was it. No more trendlines to be drawn, at least ones of 2-3 points or more. The INDU break was a severe break but the market was SEVERELY overbought.

My next chart, that of the daily Nas 100 is 'simpler' in that there were only 2 well-defined up trendlines that got drawn (and got pierced) before the big break that occurred last week.

The lower portion of the chart above helps me answer one other mailbag question:

MAILBAG:

"... of the tools you use what was screaming exit puts on the Friday close? With the much higher opening on Monday, it sure went against me to hang in over the weekend."

MY RESPONSE:

One thing was just market savvy; the sell off seemed so overdone (and mysterious) relative to what could have been driving it. The other chart/indicator aspect was definitely the arrival finally, after many months, of an 'oversold' market again in terms of the 13-day RSI seen above. An RSI indicator set to update every tick (as if it was the Close) was showing the oversold level on the daily charts in time to easily exit puts before the Friday close. Anything else was 'gambling', versus sober risk to reward calculations.

You had to ask yourself, 'what are the odds of another big decline on Monday'? That possibility was low given the magnitude of the sell off already and because, over a weekend, governments could take substantial steps to stem market unrest. Another old trader saying from my days of trading the wild and wholly futures markets: "Take QUICK profits"; i.e., especially on the downside breaks which get to a final conclusion so often so quickly.

On the subject of trendlines and the NDX, the index is back ABOVE its weekly up trendline as seen on my next chart. I often say that a 1-bar close below an up trendline is not definitive, in terms of a trend reversal, if the stock or index regains the trendline on the next 'bar' or next trading period being charted; e.g., hourly, daily or weekly. Also, the weekly NDX now seems to have such an obvious double top in the 2056-2059 area in hindsight. I was sucked in too to a degree into the strong bullish outlook and figured that that prior top wasn't going to necessarily be a big stopper or anything. WRONG!

BASIC TECHNICAL ANALYSIS; TREND CHANNELS:

In two prior Trader’s Corner articles, I've bisected and dissected trendlines and their use. Building further on this prior information about the construction and best use of trendlines takes me to the use of trendline price channels.

There is frequently a tendency, especially in the stock indices but also in individual stocks, for prices to trend higher or lower not only in relation to up or down trendlines, but also to trade WITHIN a price channel formed by a second trendline drawn PARALLEL to the dominant trendline.

Not only do prices tend to come down to an up trendline in a rising trend and then rebound, beginning a move to still higher levels, but there also often tends to be an ever-rising area where prices find resistance on rallies. In a rising trend, resistance (areas of selling interest) often rises along a straight parallel line linked to the up trendline. In an uptrend or downtrend, the two parallel lines form a rising or declining trend channel.

In an uptrend, we start channel construction with an up trendline. Ongoing buying on price dips, will tend to place an effective floor under a rising trend. A line through these downswing lows forms the up trendline. As well, there will develop areas where scale up selling goes on in an uptrend; e.g., by traders who take periodic profits on long positions and from shorting by bearish traders on the stock or index. If a line is drawn through the various rally PEAKS, it often will form an upper boundary of a rising trend.

Conversely, in a downtrend, there can develop a falling 'line' of support that runs parallel to a declining trendline; i.e., an area of selling interest or 'supply' on the way down, related to scale-down selling, as traders take periodic profits on short positions by covering short positions. Of course those who are bullish also do scale-down buying. Hey, if a stock was 'cheap' at 50, it’s even 'cheaper' at 40; or so goes the sometimes wishful thinking on the Street of Dreams.

PRICE CHANNELS:

A price channel is constructed by drawing a line parallel to either an up or down trendline that slopes in the same direction. A trendline is the first requirement, which can be constructed after 2-3 lows or highs form. The second, parallel, line can then initially be constructed with only ONE high or low point, which is a concept quite different than the rule for drawing the underlying trendline. Charting software will usually allow placement of a line parallel to another, as long as you have an initial trendline.

In an uptrend there are minor price swings that go with and against the direction of the trend. The downswings are used to define an uptrend line. The top of the first upswing can be used to define the upper boundary of a potential trend 'channel' within which a trend tends to proceed as seen below.

CHART EXAMPLES BELOW, EXCEPT FOR MY LAST ONE, ARE TAKEN FROM MY (ESSENTIAL TECHNICAL ANALYSIS) BOOK FOR ILLUSTRATION OF THE CHARTING PRINCIPLE INVOLVED.

The chart above shows how an uptrend channel is constructed. The upper channel line in an uptrend tends to define resistance, or a rising area of selling interest, as prices trend higher.

Note here that after the first 2 downswing lows seen above allowed the initial drawing of an up trendline, the first rally high AFTER these two lows, then defined a 'line' of resistance not only going forward, but going back in time as well by extending the line backward from that point. This is an interesting aside only, as the useful aspect of the upper channel line here is to see where the next rally highs might come in.

There tends to be 3 results after selling pressure, at the upper end of the channel, acts in such a 'deflecting' manner: (1) prices continue higher but stay just under or around the upper channel line, (2) there is a pullback to around the middle of the channel, OR (3) prices drop back to the low end of the channel, or back to the support trendline.

If there is a subsequent high that forms that is above the first top that has been used to construct the upper channel line, it is typically redrawn with a parallel line that goes through this higher high as is seen in the chart below.

The widest point is used to construct the opposing channel line relative to the trendline. This, because we want to see the widest possible parameters for our channel, in keeping with its intended use to define potential extremes within the price boundaries traversed by a trend in its upside or downside 'trajectory'.

An example of a downtrend channel is provided in that next chart, that of General Electric (GE) below.

There is always a point or an area where prices get ahead of themselves in an uptrend or downtrend; i.e., prices overshoot a reasonable valuation level for the moment. Market prices as we know often go from undervalued to overvalued and back again. Prices get over or under valued within the dominant trend and they will then adjust accordingly.

The usefulness of a channel line is that the upper boundary line of an uptrend channel and the lower boundary of a downtrend channel are potential areas for both profit taking and trading against the trend; e.g., for short-term traders. In addition, investors looking for an improved price entry may want to look for a price channel line to buy/sell against, if one can be defined.

After the upper line is reached in an uptrend channel, there is an increased likelihood that prices will dip from there, such as to the approximate midpoint of the channel or lower. This tendency also suggests that a better (cheaper) price entry, on a reaction or countertrend move, is a likely possibility once the top or bottom end of a channel is reached.

The channel pattern does not always appear nor, once constructed, do the boundaries always deflect and contain the price swings that unfold during a trend. However, when you do see this pattern holding up over time, it often works quite well in defining the pause or 'resting' places for price swings. And, if prices break out above or below a price channel that has existed for some time already, it’s a reason to look more closely at what is happening.

A sustained upside breakout above a well-defined uptrend channel is an indication that the trend momentum and strength are accelerating in the direction of the dominant trend. If there is a decline under a lower channel boundary, it’s no different than any similar trendline break and is a likely reversal sell 'signal'.

Anyone who follows my Index Wrap weekly commentaries know that I make extensive use of trend channels, ranging from use with hourly, daily to weekly charts. The reason you see them from me a lot is that trend channels form a lot, in both indexes and individual stocks.

My last chart, highlighting the past few months of hourly price action, shows what happens when the Nasdaq 100 (NDX) Index fell below its well-defined uptrend channel. Bye-bye.


GOOD TRADING SUCCESS!