Tips on Technicals - Trend Breaks in Studies
The building blocks of price analysis can be applied to derivative values such as studies and formulas. By applying some of the basic techniques to them interesting things can happen.
Advanced Warning
Technical trends and trend breaks are commonly used techniques for analyzing bar charts. They are also valid for analyzing momentum indicators such as Relative Strength and can provide information as to the internal strength in the market. As discussed in the "Divergence" chapter, indicators can move in one direction while the price action they are following is moving in the other direction. For example, Stochastics can be falling while prices are rising. This indicates that the internal structure of the market is weakening and prices are likely to stop rising, if not start to fall.
The same type of information can be found in the trend of the study. In the above example, the Stochastics could have been trending higher with price, making higher highs and higher lows. A possible price trend change is forecast when the study makes a lower high as price continues to make a higher high. The price reversal is closer when the study breaks its own trend line, even before it sets a lower low.
Figure 1 shows the S&P 500 Cash Index for one year. The trend line for the rally beginning in June 1994 was broken on September 20 but the 14 day RSI and the 14 day Slow Stochastics studies both broke their trend lines nearly two weeks earlier. This information should not trigger an immediate sell of the S&P 500 but it allows the trader to get positioned for a likely sell-off.
The same situation developed for the rally that began in December 1994. In this case, the studies are showing both divergence and trend breaks, providing an ominous signal for US stocks. However, the rising trend in price was never broken, reinforcing the need to let the market, not the analyst, tell us what it's going to do. Figure 2 shows a similar but longer-term situation for the Australian stock market (All Ordinaries). In addition to the other studies mentioned, the MACD had shown a trend break several days before the breakout in prices.
The use of this technique must be adapted to the market as the stock market in general gives good signals while other markets, such as gold and currencies, do not always give such advance warning.
As with most technical indicators, this technique works in all time frames. Figure 3 shows a weekly chart for the Nikkei 225 Index. Both RSI and MACD provided warning more than six months earlier that the long slide in Japanese stock prices was nearing an end, at least temporarily.
Summary
When momentum indicators show technical reversal patterns, it can mean that prices will soon follow suit. The trend breaks in studies seen here all occurred at or just after market peaks or bottoms. While aggressive traders may initiate trades at these times, it is more prudent to wait for the confirmation of a break in price trend.
