THE MORNING STAR - The Technical Analyst · charting technique from Japan GBP/USD Will defences hold? Jerry Ficchi, senior technical analyst at Brown Brothers Harriman, marks out

A powerful candlestick pattern

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.technicalanalyst.co.uk wwwThe publication for trading and investment professionals

THE MORNING STAR

Outlook for GBP/USD Japanese charting

The essentials of

Ichimoku

Support and resistanceQuantifying their

strengthWill defenses

hold?

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WELCOME

March/April 2005 THE TECHNICAL ANALYST 1

© 2005 Clements Biss Economic Publications Limited. All rights reserved. Neither this publication nor any partof it may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic,mechanical, photocopying, recording or otherwise, without the prior permission of Clements Biss EconomicPublications Limited. While the publisher believes that all information contained in this publication was correctat the time of going to press, they cannot accept liability for any errors or omissions that may appear or loss suffered directly or indirectly by any reader as a result of any advertisement, editorial, photographs or othermaterial published in The Technical Analyst. No statement in this publication is to be considered as a recommendation or solicitation to buy or sell securities or to provide investment, tax or legal advice. Readersshould be aware that this publication is not intended to replace the need to obtain professional advice inrelation to any topic discussed.

CONTENTS 1 FEATURES

An introduction to Ichimoku

An overview of a much talked about charting technique from Japan

GBP/USDWill defences hold?

Jerry Ficchi, senior technical analyst atBrown Brothers Harriman, marks out the

levels where cable is likely to find support.

The Morning StarA powerful candlestick pattern

How three consecutive candlesticks can signal the bottom of a trend.

MAR/APR

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With EUR/USD approaching an all-time high, economists continue to highlight theunsustainably large trade deficit as justification for further USD falls. Yet techni-cians, whilst always happy to follow the trend, are on the look out for signs of areversal. In this context, two leading analysts give their views on GBP/USD and

EUR/USD. We also present some useful tools, such as the Morning Star candle-stick pattern, that can be used across all markets to spot when prices are likely to

correct or begin a trend reversal.

The Technical Analyst is pleased to announce a seminar to be held in May entitled"Technical Analysis in the FX Markets". Full details can be found inside this issue.

We hope you enjoy the magazine.

Matthew Clements, Editor

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INDUSTRY NEWS

MARKET VIEWS EUR/USD: Preparing to descendGBP/USD: Will defences hold?

TECHNIQUES The Morning StarOptions open interest - A two way indicatorSell in May - The month to exit stocks?An introduction to IchimokuMarket timing using the NYSE Bullish % Measuring the strength of support and resistanceSwing trading with flow charts

THE TECHNICAL ANALYST TALKS TO…Murray Gunn, Standard Life Investments

SUBJECT MATTERS New theoretical light for technical analysis

SOFTWARETradermade 404 & The Cube

BOOK REVIEWThe Psychology of the Foreign Exchange Market, by Thomas Oberlechner

COMMITMENTS OF TRADERS REPORTLONG-TERM TECHNICALSTRAINING AND EVENTS DIARY

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12151822252931

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CONTENTS 2 REGULARS>

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"It always amazes me how some peopledisdain the phrase 'trend following."Murray Gunn, Standard Life Investments

"AMH could well be the theoreticalfoundation that technical analysis hasbeen missing"

Smith Barney, the brokerage arm ofCitigroup Inc., has laid off its entireNew York based technical analysisteam as part of Citygroup’s ongoinground of cost cutting. Technicalanalysis at the bank was headed byLouise Yamada who oversaw a nine-

strong team of analysts and supportstaff. All of Smith Barney's technicalresearch will be handled instead byDorsey Wright, a US research housewhich also provides technical analy-sis to firms such as Wachovia andDain Rauscher.

Reuters has launched a new electron-ic trading service which allows banksand financial institutions to tradefixed income securities over theirReuters desktop. Reuters Trading forFixed Income (RTFI) went live onFebruary 21st with tradable prices

from Deutsche, DrKW, JPMorgan,Rabobank, RBC and UBS. RTIFallows users such as asset managersand hedge funds to trade more than12,500 cash fixed income securities,including government and corporatebonds, across 21 currencies.

4 THE TECHNICAL ANALYST March/April 2005

REUTERS LAUNCH FIXED INCOMEDESKTOP TRADING

Smith Barney lay-off US technical analysis team

Industry News

ICHIMOKU’S CLOUDSThe Japanese charting technique -Ichimoku Kinko Hyo - is beingmisused, ultimately leading to trad-ing losses. This is the conclusion ofRick Bensignor, chief technicalstrategist at Morgan Stanley inNew York.

Bensignor's recent commentswere made with reference to anIchimoku presentation he madelast November at the annual IFTAconference, after which manytraders went away and started usingthe technique. "I certainly didn'tdescribe the whole model, and Imade that clear," said Bensignor."Unfortunately, as is the case whenpeople think they have a grasp onsomething, but truly don't, lossesoccur."

Certainly, there is some confusingdebate over the technique, evenwith regard to which marketsIchimoku should be applied to.Shaun Downey, technical analyst atCQG, and Steven Smith, Telerateproduct manager, both sayIchimoku works best for Japanesemarkets such as JGB's, Nikkei andthe yen. Other analysts, such as GilLi of Hong Kong based firmProSticks, say Ichimoku is simplyanother charting method and canbe applied to all markets.

A large part of the uncertaintystems from the lack of advancedreference material on the subject,at least in the West. Bensignorplans to fill this gap with a book onIchimoku due out later in the year.

FX Seminar in May The Technical Analyst magazine willbe hosting a one day event entitled“Technical Analysis in the FXMarkets,” where anyone who usesTA in the currency markets - traders,

hedge funds and fund managers –has the opportunity to meet and lis-ten to leading analysts. The eventwill be held on the 12th of May inLondon. Key speakers from UBS,

Citigroup and Rathbones, amongothers, will be discussing the latestissues in charting the FX markets.Further details can be found onpages 34 and 35.

The Chicago Mercantile Exchangehas released two new data products;BBO and MD. The BBO (BestBid/Offer) includes: best bid, bestbid volume, best offer, best offervolume, last sale and volume of lastsale data. The MD (Market Depth)includes the five highest bids andfive lowest offers. The products canbe purchased per contract or by con-tract group and the data is taken

from all CME Globex traded prod-ucts and can be processed daily,weekly or monthly for a subscriptionor one-time purchase. According toAllan Schoenberg, director of tech-nology communications at the CME,"the new products are designed tomeet the needs of customers such ashedge funds who are building oradding to their automated and non-automated trading models".

NEW CME PRODUCTS FOR HEDGE FUNDS US Treasuryissuance falls by20 percent

US government bonds issued in2004 fell to $5.48 trillion from $6.81trillion in 2003 according to the USBond Market Association (BMA).The BMA says that stronger USeconomic growth and higher short-term interest rates contributed tothe decline in total issuance.

Robin Griffiths has joined RathbonesInvestment Management in Londonas head of asset allocation. He waspreviously head of technical analysiswithin the investment banking armof HSBC. Griffiths is responsiblefor writing regular strategy andinvestment reports for Rathbonesclients.

Trevor Neil has quit his post as headof technical analysis at Bloomberg tojoin South African hedge fund,Isivuno. He is replaced by GuidoRiolo, formerly an assistant to Neil,who takes on the role of ‘TechnicalAnalysis Applications Specialist’based in London.

Industry News


E X C H A N G E N E W S :

Exchanges report record volume in February

The Chicago Board of Trade (CBOT) has reported its most successfultrading day ever on February 29th with 5,852,889 contracts, beating theprevious record set in November last year. Exchange-wide volumereached a new monthly high in February with total volume at 61,399,407contracts, up 40.1% from February 2004. The CME also reported recordaverage daily trading volumes for February of 3.8 million contracts, up50% from the same month last year.

The London Stock Exchange has announced February as the busiesttrading month on record for the exchange, with an average 308,932trades per day across all products. This is the first time that average dailytrading volume has exceeded 300,000 and is a 16% rise on February2004. The LSE says volume continues to be driven by SETS, theexchange's equity trading service.

Eurex has reported turnover of around 100 million contracts in February, a 24% increase on the same month lastyear. Trading in the Euro-Bund future reached a record high of 27.2 million contracts, up 57% on February 2004.

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Market Views

Over the last three years one of the most persistenttrends in the foreign exchange markets has beenthe strengthening of the European currencies

against the USD. The trend has been well discussed and dis-sected by the press, particularly as EURUSD hit its all-time-highs in December 2004 at 1.3670. At that time, the presswas flooded with articles discussing the plight of the USDand how much further it had to fall. The frenzy thatoccurred as EURUSD hit the highs in December 2004 was,however, followed by a very sharp and significant correctionlower. This correction enabled a number of patterns toform - with the most notable developments being on themonthly charts - indicating this may have been the blow-offtop in EURUSD. These indicators build a strong case thatrather than extending downside targets on the USD, this isthe time to do the exact opposite and to look for opportu-nities to benefit from a strengthening of the USD againstthe European currencies.

Support at 1.25 (Figure 1)To set the scene, a well-defined uptrend has been in placesince EURUSD based at 0.8563 in late January 2002. Thecurrent trend-defining supports converge on 1.2500: specifi-cally the 55 week moving average at 1.2531, the uptrendfrom the October 2002 lows at 1.2627 and the highs of theJuly 2004 consolidation at 1.2462. There have been numer-

ous developments on the monthly and weekly charts whichgive a strong signal that these supports should be testedover the coming weeks and months, but which also arguethat this time around (in contrast to the corrections downfrom the May 2003 and February 2004 highs) these sup-ports may break to deliver a much larger and more signifi-cant correction of the long-term trend.

Monthly technicals (Figure 2)The purest technical developments have come through onthe monthly charts. First, from the highs of the EURUSDbull-market, the price action during January 2005 formed abearish engulfing candle pattern (the January 2005 opengapped above the December 2004 close, then closed belowthe December 2004 open). This is the first bearish monthlypattern (from an extreme) in the rally up from the 0.8228low in October 2000. To accompany this, negative monthlystochastic divergence has formed against the May 2003,February 2004 and December 2004 highs (higher highs inthe spot price not being confirmed by higher highs on themomentum indicators). This momentum divergence indi-cates the decreasing willingness of market participants toenter - and crucially - maintain long EURUSD positions asthe currency pair moves towards the top of its multi-decade range. The last time this type of divergence was

EUR/USDPREPARING TO DESCEND by John Noyce

Monthly charts indicate European currencies are attempting to build a top against the USD.

Figure 2. Monthly EURUSD chart showing bearish engulfing monthand negative divergence. Source: Aspen Graphics. Data: Reuters

Figure 1. Weekly EURUSD chart showing long-term supports.Source: Aspen Graphics. Data: Reuters →→

Market Views


seen on EURUSD was at the lows in 2000, where triplepositive divergence was observable. It has effectively takenaround twenty months for this development to take shape -an event that is unlikely to be seen more than once or twicein a decade.

Percentage weekly declines (Figure 3)The two pure technical developments in Figures 2 and 3offer compelling enough evidence for a test of the supportcentred on 1.2500. So what other evidence is there to thinkthis may be a more significant turning point? Firstly, theopening week of this year saw EURUSD decline by 3.62% -a statistically rare and significant piece of price action.There is a strong precedent from the two prior major turn-ing points in 1992 and 1995 that following significant highs,EURUSD posts a large percentage weekly decline: inSeptember 1992 EURUSD set a major high of 1.4577(according to Reuters synthetic EUR data) and then postedits largest ever weekly decline of 6.68% in the followingweek. Again, following the high in April 1995 at 1.3525,after a period of consolidation, EURUSD posted anothermajor decline of 3.75% in the second week of May. Theonly other times moves of this magnitude have been seenwere during the basing process in 2000/2001.

Consecutive weeks up (Figure 4)Along similar lines to Figure 3, another piece of evidencerelates to the number of consecutive positive weekly closeson EURUSD. Into the highs in October 1998, nine consec-utive positive weekly closes were posted. Similarly into theJanuary 2004 high at 1.2898, nine consecutive positiveweekly closes were also seen. And into the highs in the lastweek of November 2004, a new record was set - elevenconsecutive positive weekly closes. Sequences of positiveweekly closes such as these have only been seen at majorturning points on EURUSD.

Sentiment (Figure 5)In Figure 2 we referred to the negative monthly stochasticdivergence recently forming against the May 2003, February2004 and December 2004 highs. This shows that on a pureprice action basis, the three major highs on EURUSD havebeen set with decreasing momentum and confidence. It isnoteworthy that a similar phenomenon shows through ifyou look at market sentiment surveys. Market Vane pro-duces what they term "Bullish Consensus Indices" on anumber of asset markets. In currencies, the most significantis the bullish consensus on the USD Index, which is anindex of the USD's value. The Sentiment Index runs from0-100, 0 effectively being bearish and 100 being bullish onthe asset in question. (For the sake of interpretation, theUSD Index effectively trades as the inverse of EURUSDdue to the high weighting of the euro in the index).

As with the monthly stochastic divergence, which showsdecreasing momentum and confidence in buying EURUSDeach time major new highs are set, the sentiment index

Figure 3. Weekly EURUSD chart with percentage weekly change(close to close basis). Source: Reuters Graphics

Figure 4. Weekly EURUSD chart overlaid with bar chart showingextreme numbers of consecutive positive weekly closes. Data Source:Reuters Graphics

Figure 5. Weekly EURUSD chart overlaid with Market Vane USDSentiment Index. Data Source: Reuters for EURUSD, www.market-vane.net for USD Sentiment Index


Market Views

shows a similar pattern. Each of the major lows on theUSD Index (June 2003, February 2004 and December 2004)has been posted with decreasing negative USD sentiment.Put another way, as the USD moves closer to the all-time-lows of September 1992, a decreasing proportion of marketcommentators and forecasters are willing to predict a signif-icant further decline in the USD against the European cur-rencies. Does history shine any light on this relationship?Yes, it does. As the USD Index made its series of highs inOctober 2000, July 2001 and January 2002, the sentimentindex (especially against the October 2000 and January 2002highs) made significantly lower highs, showing decreasingpositive sentiment on the USD. We all know what happenedfrom there; the USD Index declined from a high of 120.51in January 2002 to a low of 80.39 in December 2004 - a fallof 33.3%.

ConclusionThere is a large body of evidence indicating that EURUSD

is likely to extend its recent correction over coming weeksand months towards the long-term supports centred on1.2500. Added to this, there are a large number of develop-ments, both from a pure price and a sentiment perspective,which indicate these supports around 1.2500 may not hold,allowing for a much larger correction to unfold this timearound.

John Noyce is technical analyst for Citigroup ForeignExchange

Copyright © 2005 Citibank N.A. All rights reserved. Any unauthorised use,duplication or disclosure is prohibited by law and may result in prosecution.CitiFX, Citigroup and the Umbrella Device are trademarks and service marksof Citicorp or its affiliates and are used and registered throughout the world.Citibank is authorised and regulated by the Financial Services Authority.

John Noyce

“THE THREE MAJOR HIGHS ON EURUSD HAVE BEEN SETWITH DECREASING MOMENTUM AND CONFIDENCE.”

Market Views


Corrective weakness should be the phrase associatedwith cable as 2005 progresses. Sterling has had astratospheric run since posting its 2001 low of

1.3675, but indications are that highs have been set for thetime being and that the rate is on its way to targeting 1.7305as a minimum before regaining its footing.

Though a bit longer-term than necessary for this forecast,but providing an excellent indication of how overboughtcable currently is,quarterly slow sto-chastics are spendingtheir fifth consecutiveperiod above 80%.It's unlikely the studywill linger muchlonger in this condi-tion, especially with abearish divergenceappearing on monthlycharts. Besides thisdivergence (higherspot highs correspon-ding with lower sto-chastic highs) - a veryreliable warning initself that the markethas overextended andneeds to correct - ashooting star appeared for December's candlestick. Ashooting star candlestick takes the form of a long uppershadow, little or no lower shadow, and a tight real body nearthe lows of the period. Though called a reversal candle, ashooting star simply implies the end of the current bulltrend and a strong tendency for corrective weakness.

The first support target for this anticipated correctioncomes in at 1.8460, represented by the 200-day movingaverage. Besides only brief flirtations beneath this movingaverage, cable has been guided higher by it since being pro-pelled in mid-2002. This well watched average may provestubborn on initial attempts, but its penetration should trig-ger sell stops and accelerate sterling's correction.

Additionally, since 2002, the 20-month moving averagehas supported GBP/USD brilliantly, providing an excep-

tional bounce in September 2003. Supportive bids are likelyto remain near it at its current level of 1.7945 with evenlarger sell stops lingering below. Its breach, especially with amonthly close posted beneath it, will finally provide a signalto those late to the sell-off that a correction is well under-way.

Corrections normally have enough follow through toretrace 38.2%, 50.0% or even 61.8% of a trend before bas-

ing. Interestingly, tak-ing the move from2001's low to 2004'shigh, an upward slop-ing trendline willintersect with theprior trend's 38.2%retracement at 1.7305in May. The doubledimportance of thissupport level shouldattract cable like amagnet, especiallygiven it roughly coin-cides with the highsfrom 1998. It's quitepossible that bids sur-rounding this congest-ed 1.7305 area may beenough to end the

correction and drive the rate higher again. If penetrated,however, there are more benchmark levels below whichwould be targeted and, in turn, take their chances in haltingthe corrective slide.

The 50.0% retracements of the underlying trend rests at1.6615 while the 62.8% level comes in at 1.5920. Betweenthese two Fibonacci retracements sit both the 100- and 200-month moving averages. Besides adding their own support,the narrowing distance between the two suggests a pendingcross that graphically depicts the market's intention of buy-ing sterling on dips over the longer-term.

Jerry Ficchi is senior technical strategist at BrownBrothers Harriman in New York

GBP/USDWILL DEFENCES HOLD? by Jerry Ficchi

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W W W. B B H . C O M

THE MORNING STARA powerful candlestick patternby Steve Bigalow

Techniques


Japanese traders say "letthe market tell you whatthe market is going to

do." Yet it is difficult at timesto sort out what marketdirection will be when listen-ing to the many scenariospresented by the financialpress. Using candlestickcharts will allow investors tofilter out the noise.

Candlestick analysis allows investorsto anticipate trend reversals with a rela-tively high degree of accuracy. Onemisconception about candlesticks sig-nals is that there are too many of themto learn. Of the 50 or so candlesticksignals, there are only about 12 signalsthat will occur the vast majority of thetime: The doji, the bullish and bearishengulfing signal, the hanging Man, theshooting star, the hammer, the invertedhammer, the bullish and bearishHarami, the dark cloud, the piercingpattern, and the kicker signal. Knowingjust these signals alone will dramaticallyimprove your analysis of trend rever-sals and allows the trader to be posi-tioned in the right direction when amove occurs.

The Morning Star signal is one of themost clear, symmetrical candlestickreversal patterns. It foretells thatbrighter things are about to occur andthat prices are going to go higher.

Three-day bottomThe signal is formed after an obviousdowntrend and reveals simple commonsense features that identify a change ininvestor sentiment. The three-day sig-nal consists of a long black body on thefirst day, usually one produced from thefear induced at the bottom of a longdecline. The following day - the star day- gaps down but the magnitude of thetrading range remains small for the day.This results from a day of indecision.The third day is a white candle day andrepresents the fact that the bulls havenow stepped in and seized control. The

optimal Morning Star signal wouldhave a gap before and after the star day.

The star day can be made up of anynumber of candle formations that indi-cate a day of indecision - with a blackor a white body - but a doji or a spin-ning top is usually the predominant for-mation. The important factor is theconfirmation of the bulls taking con-trol the next day. That candle shouldconsist of a closing more than half-wayup the black candle of two days prior(Figure 1).

It's worth noting that the oppositebut equivalent signal to the MorningStar - the Evening Star - starts with alarge white candle body and foretells ofprices heading down.

Signal strengthIdentifying the Morning Star signal isrelatively easy. There are some verysimple parameters that can enhance theMorning Star signal's probabilities ofindicating a reversal:

1. The longer the black candle and thewhite candle, the more forceful thereversal. This demonstrates a more dra-matic change in investor sentiment2. The more indecision that the star dayillustrates, the greater the probabilitythat a reversal will occur.3. A gap between the first day and thesecond day adds to the probability thata reversal is occurring. A gap beforeand after the star day is even moredesirable.4. The higher the close of the third day,coming up past the middle point of theblack candle of the first day, revealsmore potential in the strength of thereversal.

Figure 1.

Techniques


→→

Techniques


The probability of a Morning Star sig-nal reversing a trend becomes extreme-ly high when found in oversold condi-tions. Using a simple indicator such asstochastics, the 20 area or below repre-sents an oversold condition. However,the most important element of the sig-nal is the magnitude of the white can-dle's close on the third day.

Candlestick analysis can be used in allmarkets and across all time frames. Asseen in the daily Dow chart (Figure 2),the Morning Star signal revealed whenthe Dow established a bottom. In Julyand August 2004, the Dow reversedafter Morning Star signals. Note pointA when the stochastics were on theoversold condition, a three-day morn-ing star signal appeared. Two MorningStar signals then appeared a week later(point B) to start the next rally. Figure 3is a chart of the stock AVI Biopharma.A Morning Star signal appeared in earlyAugust just as the markets were bot-toming and successfully anticipated thebeginning of a short-term rally

Candlestick signals occur in the mar-kets everyday and charting softwaremakes finding these very easy. Theidentification of the simple MorningStar signal, occurring in oversold condi-tions, allows you to anticipate a trendreversal and offers a good chance of amaking a successful trade.

Stephen Bigalow is director and edi-tor of www.candlestickforum.com,a website providing informationabout Japanese candlestick invest-ing.

Figure 2.

“THE PROBABILITY OF A MORNING STAR SIGNALREVERSING A TREND BECOMES EXTREMELY HIGHWHEN FOUND IN OVERSOLD CONDITIONS.”

Figure 3.


Successful trading isabout finding a uniqueedge that gives you an

advantage on others. Oneapproach we use is to main-tain an awareness of openinterest changes on call andput options - a commonlyneglected area of analysis.This information gives ustwo crucial insights. First, ithelps us gauge market senti-ment. And second, it can beused to pinpoint significantsupport and resistance levelson the underlying stock orindex.

What is open interest?Open interest is the number of out-standing contracts on a particularoption class or series. When a buyer isentering a new long position and the

seller is simultaneously opening a newshort position one contract is created.

It is important to realize the distinc-tion between open interest and volume.Volume simply refers to the number ofcontracts that trade on a particularoption during the day. It provides anindication of the level of activity on anoption, yet unlike open interest, volumedoes not provide a clear indication ofoption demand. For example, anoption could have volume of 1,000contracts in a day, yet open interestcould increase, remain unchanged, ordecrease. It is the daily assessment ofthe sum total of activity - in the formof open interest - that is of more use asan indicator of sentiment.

A sentiment indicatorSome options analysts only look at theput and call volume on a stock or indexeach day. We have found that by study-

ing open interest and open interestchanges, one can easily surmisewhether or not put and call volume isresulting in a liquidation of currentopen contracts or a further accumula-tion of contracts. Open interest issmoother data than volume because itis calculated based on changes from theprior day's open interest, while volumestarts anew each day.

A comparison of total call open inter-est to total put open interest can give ananalyst a snapshot of the sentiment onan underlying stock, index, or futuresinstrument. Such data can be collectedon a daily basis and used to pinpointextremes in optimism and pessimismfor the particular underlying by calcu-lating a put/call open interest ratio.The higher the ratio, i.e., the higher therelative level of puts to calls, the higherthe pessimism. Conversely, the lowerthe ratio, the greater the optimism.

OPTIONS OPEN INTERESTA two way indicator by Jon Lewis & Todd Salamone

Techniques

→→

Techniques


By analyzing open interest changes, onecan come away with a more accurateunderstanding of the sentiment amongoptions speculators.

Some might argue that not all openinterest is generated by buyers and thatit would be too simplistic to claim thatput open interest, for instance, is pure-ly the result of pessimistic sentiment.While it is true that option selling canrepresent a material portion of openinterest, the majority of option activityand changes to open interest comefrom the buy side.

Furthermore, selling options does notnecessarily represent sentiment exactlyopposite from that of buying. Forexample, straight call buying is clearlybased on the expectation that theunderlying stock or index will rise. Butcall selling is not in itself a vote for thedownside. Why? Most call selling takesthe form of covered call writing. Onecould argue that selling covered calls isnot outright bearish, but more of aneutral-to-bullish strategy in which theseller is looking to generate additionalincome while maintaining a position in

the underlying stock. If an investorwere truly bearish, he would more thanlikely sell his shares, short the stock orbuy a put. A similar point could beargued on the put side. Selling out-of-the-money puts can be a successfulstrategy if the stock stays flat or evendrops somewhat. As long as the putstays out of the money, the put sellerwill enjoy a successful trade. Thus, wemaintain that open interest taken in itsentirety can be reflective of optimismand pessimism.

We take the analysis of open interestone step further by using options withthree or less months to expiration.These short-term options tend toattract a more speculative crowd andare thus more reflective of the currentsentiment. The resultant ratio isreferred to as the Schaeffer's put/call openinterest ratio (SOIR).

One thing to realize about individualequity open interest is that while thetheme of pessimism being bullish andoptimism being bearish generally holdstrue, each stock's put/call ratio isunique and has its own timing implica-

tions. There are several ways we useSOIR to analyze sentiment - absolutelevels, relative levels, and in conjunctionwith technical factors. On an absolutebasis, most stocks will have greater callopen interest than put open interest.Thus, when puts outnumber calls(SOIR greater than one), this tends tosuggest that pessimism is running highon a stock, although this is not neces-sarily the case for all equities. One wayto accurately judge the relative opti-mism and pessimism on a stock at aparticular time is to compare the cur-rent SOIR to its own previous readings.We track the put/call ratios for over2,000 stocks and 30 sectors over theprevious year and compare each dailySOIR to the previous year's worth ofreadings. By doing this, we are able tocalculate a percentile ranking for thecurrent SOIR to capture the currentrelative sentiment environment.

The most important considerationwhen interpreting SOIR is to view thedata in light of the current technicalbackdrop for a stock or index. Forexample, one would expect that a strug-gling stock would have an SOIR that istrending higher. Likewise, optimism inthe form of a low SOIR would logical-ly accompany a stock that is breakingout to new highs. It is when optionplayers and the underlying trend are incontrast that we can begin to getstronger reads on a stock's future direc-tion. For example, a stock in a stronguptrend that has an SOIR that is alsotrending higher (i.e., rising pessimisticsentiment) is enjoying a very bullishenvironment as fear indicates that thereis plenty of buying power in reserve tokeep the trend intact. In contrast, adeclining SOIR for an underperform-ing stock entrenched in a decline paintsa bearish picture as there is little buyingpower available to reverse the trend.Thus, sentiment should not be viewedas a static, one-dimensional indicator.Sentiment trends within the context ofthe technical environment will give theinvestor a clearer picture of a stock'spotential.

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A technical indicatorAnother way to use open interest is toanalyze a stock's open interest configu-ration (the number of puts and calls atvarious strike levels) to pinpoint poten-tial support and resistance levels. Forexample, Figure 1 shows the openinterest for the April series on ExxonMobil (XOM) from a few years back.Note that the 85 strike contains themost call open interest while the site ofpeak put open interest is the 70 strike.Also note that the stock was well con-tained between the 70 and 85 strikesthrough to the expiration of these Apriloptions.

How do these levels act as potentialsupport and resistance points? First,round-number levels tend to serve assupport or resistance as investors viewpullbacks to levels such as 70 for XOMas good entry points for long positionsor potential closeout points for shortpositions. In the same fashion, traderswill sell their long positions or go shortfollowing rallies to round-number lev-els like 85. Heavy open interest at thesestrikes can emphasize this support orresistance.

In the case of XOM, those who soldthe April 85 calls had a vested interestto see the stock remain below 85, asthey were vulnerable to large losses ifthe stock rallied above the 85 level.These sellers can often induce resist-ance by adding selling pressure when

the stock approaches this critical level.Likewise, put sellers have a major stakein seeing the stock stay above the 70strike so that their sold puts expireworthless.

We should also note that these strikesdo not always act as precise resist-ance/support levels. This is often thecase when calls or puts build up on farout-of-the-money strikes, as most ofthe written options are unhedgedbecause of the low deltas for out-of-

the-money options. However, as thestock moves closer to the out-of-the-money strikes, those that sold theseoptions will feel more pain as the deltaincreases and they are forced to hedgetheir positions.

For example, those that sold calls maybegin buying the underlying stock,

while those that sold puts may beforced to short the stock. Delta hedg-ing - the process of hedging more ofthe underlying stock as it moves closerto the strike price - can therefore resultin temporary surges through the strikeprice.

When a weak stock (one for whichsupply exceeds demand) overcomespotential call resistance due to deltahedging, the move will typically reversequickly back below the strike price ashedging activity begins to decrease. Onthe other hand, a strong stock will like-ly stay above the strike price as non-hedging demand continues to bestronger than supply. Also, if there is asignificant penetration of the strikeprice due to this heavy demand, addi-tional demand from the delta hedgingprocess can add to the upside momen-tum.

The important lesson is that it isadvantageous to be aware of openinterest at various strike prices to knowwhy a stock behaves in a manner thatmost other investors and traders do notunderstand. Such knowledge can giveyou the edge needed to give your port-folio a boost.

Jon Lewis is editorial director andTodd Salamone is vice president ofresearch at Schaeffer's InvestmentResearch.www.SchaeffersResearch.com

“WHEN OPTION PLAYERS ANDTHE UNDERLYING TREND ARE INCONTRAST... WE CAN BEGIN TO

GET STRONGER READS ON ASTOCK’S FUTURE DIRECTION.”

JonLewis

Techniques


The market adage 'Sell inMay' is one of the mostprofitable, if not the

most profitable and simpleinvestment rule of thumbavailable to investors.

It is profitable because, on average,stock prices rise during winter. Duringthe summer, stocks, at best, performonly as well as a savings account. It issimple because all investors have to dois to buy at the beginning of Novemberand sell at the start of May. Who saidinvesting was exciting? It seems to beno more than rather tedious calendar-watching.

The seasonal pattern of stock mar-kets occurs almost everywhere. Figure1 shows the total returns for allEuropean country indices that go backto 1970, as well as for the United Statesand Japan. We define the winter periodas the six months from November toApril and the summer period as themonths from May to October. In onlythree European countries is the excessreturn, defined as the return on thestock market minus the short-terminterest rate, positive during the sum-mer period. These countries areDenmark, Switzerland and Norway. Forall the other countries it would havebeen better to sell equities at the startof May and put the money in a depositaccount. In winter, however, the stock

market is a much better alternative. Onaverage excess returns vary fromroughly 4% for Denmark to 12% forSweden. This seasonal pattern is notjust a European phenomenon - theAmerican and Japanese stock marketsalso flourish in the winter.

The Sell in May effect is more than aJanuary effect. Figure 2 shows averagemonthly returns. Here, we use anunweighted average of the marketsused in Figure 1, i.e. Europe plus theUnited States and Japan. As can beseen, three months in the summer peri-od show negative average excessreturns. January appears to be no morethan just a reasonably good month -returns in December and April arehigher. The presence of a seasonal pat-tern in the stock market is clear, but weare still left with the question of whereit comes from?

Although there is no consensus aboutwhat causes it, the literature providesthree explanations for the Sell in Mayeffect. Firstly, there is the summer holi-day-based explanation. Tworesearchers, Bouman and Jacobsen,showed that the size of the effect is sig-nificantly related to both the length andthe timing of vacations. However, theybelieved that "arbitrage is a forcefulargument against this empirical link"and that "it is still a mystery why stocks'performance can oscillate so regu- →→

Techniques


SELL IN MAYTHE MONTH TO EXIT STOCKS?by Ronald Doeswijk

Techniques


larly."Secondly, there is the winter depres-

sion explanation which attributes theseasonal pattern to a risk-varying equi-ty premium influenced by the SeasonalAffective Disorder (SAD), the so-calledwinter depression. This says that

depression lowers one's willingness totake risk. So in the autumn the risk pre-mium rises and prices fall, but as soonas the days get longer, the risk premiumdecreases and prices rise.

Thirdly, we have the optimism cycle-based explanation in which I argue that

the perceived outlook for the economyand earnings varies during the yearaccording to a seasonal pattern. As yearend approaches, market participantsstart looking forward to the next yearand are overly optimistic about thegrowth prospects for the economy andearnings. So, during the winter, the out-look for stocks is relatively good. Thispattern reverses around the time of thesummer lull in the stock market.

The winter depression theory hasreceived a lot of criticism, especiallybecause of its assumption that depres-sion peaks in December. The optimismhypothesis is new and has not yet beendiscussed thoroughly within the invest-ment community. The question as towhat causes the seasonality is a highlyinteresting one. For investors, however,the explanation is probably less of aconcern as history still suggests theyonly have to take a look at the calendarto determine whether to be over- orunderweighted in stocks.

Ronald Q. Doeswijk is GlobalStrategist at the Institute forResearch and Investment Services(IRIS), research enterprise ofRabobank and Robeco, theNetherlands.Figure 2. Average monthly total return 1970-2004 (Europe, US and Japan). Source: MSCI, IRIS

(Rabobank/Robeco)

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Figure 1. Total return from November through April (Winter) and from May through October(Summer) from 1970 through 2004. Source: Morgan Stanley Capital International indices, IRIS(Rabobank/Robeco)

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Sell in May factsheetTransatlantic distinction

One of the market's favourite sayings is "Sell in May and go away but buy back on St Leger Day". St Leger refersto the classic horse race run every September since 1776 at Doncaster. In the US, investors are advised to hold outfor a bit longer - until Halloween on the 31st of October.

A long-standing observation

The Sell in May effect is not a recent phenomenon. Evidence shows that in a number of countries it has beennoticeable for a very long time, and in the UK - where the anomaly can be seen as far back as 1694 - the effect issignificant with 13.1 per cent return in the winter against 0.9 per cent in the summer months.

Emerging markets also seasonal

Looking at the period from 1970 to 1998, we found that the stock returns have been higher in the November-Aprilperiod than in the May-October period in 36 of the 37 established and emerging markets in our sample. In mostEuropean and Asian markets the effect was strongly manifest. Even in the world's most efficient market, the US,investors enjoyed 8.5 and 3.0 per cent respectively. Only in New Zealand was the anomaly absent.

Statistically significant

In a study published in the American Economic Review we showed that the economical and statistical significanceof this calendar anomaly is considerable. In 20 of the 37 stock markets we examined, the 'Sell in May' pattern isstatistically present at a 10% significance level, much more than pure coincidence. In theory stock market anomaliesshouldn't persist because they offer investors a free lunch and should be arbitraged away. But this anomaly does not- at least not yet - seem to disappear or reverse itself after its discovery.

Trading Strategy

By switching to savings in May and buying stocks back around the end of October a British investor would haveenjoyed the winter market return plus six months' interest, giving an annualised return of 16.9 per cent from 1970to 2004. By comparison, a 'Buy and Hold' investor would have enjoyed an average 12.5 per cent over the same peri-od. With just two trades a year the superior returns are not being wiped out by transaction costs. This simple trad-ing strategy would have outperformed a buy and hold portfolio in most countries we studied, and would also beless risky because half of the time the assets are stored in risk-free savings deposits.

Although there are no guarantees this strategy continues to hold, the Sell in May effect is potentially interestingfor investors. For most professionals their mandate does not allow them to switch from cash to stocks and backagain like this. But by changing their asset allocation within the bandwidths they can still trade on it. Anotheroption is to use portfolio insurance during the May through October period. Pure equity investors can also benefitfrom it by making adjustments to their style allocation, i.e. holding the more cyclically orientated stocks such asindustrials during the winter months and the more defensive sectors such as utilities and pharmaceuticals during thesummer months.

Sven Bouman is a senior portfolio manager at AEGON Asset Management in The Netherlands.Ben Jacobsen is visiting professor at Massey University in New Zealand.

Techniques


AN INTRODUCTION TO ICHIMOKUby Gilbert Li

The Ichimoku Kinko HyoJapanese charting techniquewas developed before World

War II with the aim of portraying - in asnapshot - where the price was headingand the right time to enter or exit themarket. This was all performed withoutthe aid of any other technical analysistechnique or study.

The word Ichimoku can be translatedto mean "a glance" or "one look".Kinko translates into "equilibrium" or"balance", with respect to price andtime, and Hyo is the Japanese word for"chart". Thus, Ichimoku Kinko Hyosimply means "a glance at an equilibri-um chart", providing a panoramic viewof where prices are likely to go and theposition one should undertake.

Invented by a Japanese journalist witha pen name of "Ichimoku Sanjin",meaning "a glance of a mountain man",Ichimoku charts have become a popu-lar trading tool in Japan, not only withthe equity market, but in the currency,bond, futures, commodity and optionsmarkets as well. The technique waspublished over 30 years ago but hasonly gained international attentionwithin the last few years.

CalculationThe Ichimoku chart consists of fivelines. The calculation for four of theselines involves taking only the midpointsof previous highs and lows, similar tomoving average studies. Yet even withthis simplicity, the completed chart isable to present a clear perspective ofthe price action.

The five lines, as shown in Figure 1,are calculated as follows:

Traders in Europe are hearing more and

more about the power of Ichimoku charting.So what is it and what

makes it superior to traditional

techniques?

1) Tenkan-Sen = Conversion Line= (Highest High + Lowest Low)/ 2, for the past 9 periods

The Kumo, or cloud, is equal to thearea between Senkou Span A and B.

Ichimoku uses three key time periodsfor its input parameters: 9, 26, and 52.When Ichimoku was created back inthe 1930s, a trading week was 6 dayslong. These parameters therefore repre-sent one and a half week, one month,and two months respectively. Now thatthe trading week is 5 days, one maywant to modify the parameters to 7, 22,and 44.

InterpretationAs can be seen from the formulas,Ichimoku is very similar to movingaverage studies. And like moving aver-ages, buy and sell signals are given withthe crossover technique.

A bullish signal is issued when theTenkan-Sen (orange line) crosses theKijun-Sen (purple line) from below.Conversely, a bearish signal is issuedwhen the Tenkan-Sen crosses theKijun-Sen from above.

Moreover, there are, in fact, differentlevels of strengths for the buy and sellsignals of an Ichimoku chart. First, ifthere was a bullish crossover signal andthe price, at that time, was tradingabove the Kumo (or cloud), this wouldbe considered a very strong buy signal.In contrast, if there was a bearish

crossover signal and the price, at thattime, was trading below the Kumo, thiswould be considered a very strong sellsignal. Secondly, a normal buy or sellsignal would be issued if the price wastrading within the Kumo when thecrossover took place. Thirdly, a weakbuy signal would be issued if there wasa bullish crossover that occurred whilethe price was trading below the Kumo.On the other hand, a weak signal wouldbe issued if there was a bearishcrossover that occurred when the pricewas trading above the Kumo.

Another striking feature of theIchimoku charting technique is theidentification of support and resistancelevels. These levels can be predicted bythe presence of the Kumo. The Kumocan also be used to help identify theprevailing trend of the market. If theprice is above the Kumo, the prevailingtrend is said to be up. And if the priceis below the Kumo, the prevailing trendis said to be down.

A final feature of Ichimoku is theChikou Span. This line can also be usedto determine the strength of the buy orsell signal. If the Chikou Span wasbelow the closing price and a sell signalwas issued, then the strength is with thesellers, otherwise it is a weak signal.Conversely, if there was a buy signaland the Chikou Span was above the

Techniques


Figure 2. GBP/USD ProSticks Ichimoku Daily Chart →→

Figure 1. Definition of Ichimoku Kinko Hyo

2)

3)

4)

5)

Kijun-Sen = Base Line =(Highest High + Lowest Low) /2, for the past 26 periodsChikou Span = Lagging Span =Today's closing price plotted 26periods behindSenkou Span A = Leading SpanA = (Tenkan-Sen + Kijun-Sen)/ 2, plotted 26 periods aheadSenkou Span B = Leading SpanB = (Highest High + LowestLow) / 2, for the past 52 peri-ods, plotted 26 periods ahead

price, then there is strength to theupside, otherwise it can be considered aweak buy signal. This feature can alsobe incorporated into the other signals.

ApplicationMost traditional technical analysis tech-niques are based on the open, high, low,close or average price. Others may usevolatility while fixed scales such asFibonacci numbers have also beenapplied. But the results are the same.Support and resistance levels are alwaysdepicted as a point or a line.

With Ichimoku charts, it is the Kumo

that quantifies support and resistancelevels and the Kumo that can be used toproject these levels into the future. It'stherefore important to note that (unlikeits traditional counterparts) the sup-port/resistance level given by the Kumoappears as a layer of varying thickness,with the thickness being related to priormarket volatility.

Let's now illustrate the Ichimokutechnique with an example.

Figure 3 is an Ichimoku daily chart ofUSD/JPY. Between August andOctober 2004, the price was in a tradingrange within the Kumo, which acted as

a support level. At point A, the pricetested the bottom of the Kumo and thissupport level held. Afterwards, the pricetraded around this level before it surgedtemporarily higher but failed to createnew highs. Soon after, the price retestedthe low (point B) made by point A. Thiscoincided with a break below the Kumowhich has since narrowed (i.e. lowervolatility) and soon afterwards a hugedowntrend commenced once the previ-ous lows were taken out.

In general, the thickness of the Kumocan be related to the strength of thecurrent support/resistance level. A thinKumo implies the current volatility ofthe market has lessened and the pricehas been narrowed into a range that astrong breakout to either side is immi-nent. On the other hand, a thick Kumoimplies a strong support/resistancelevel coupled with high volatility.

Short & long-term implicationsOne might wonder then what implica-tions Ichimoku has regarding short-term versus long-term trading. Onegeneral application is that by comparinga daily and a weekly chart, a price chan-nel can be identified.

This can be illustrated with theUSD/JPY weekly chart in Figure 4.

One can quickly observe that the pricehas been trading below the Kumo on aweekly basis for the past two and a halfyears. Comparing this with the dailychart in Figure 3, one can see that theprice drop in October 2004 coincidedwith the price hitting a strong weeklyresistance level.

So by comparing Ichimoku charts ofdifferent time frame, one can gaugewhere support and resistance levelsexist and then better position oneself inthe market.

This article only scratches the surfaceof this wonderful charting techniqueand as more charting applications pro-vide this tool for traders, I believe thatmost traders will not want to trade with-out it.

Gilbert Li is chief operating officerat ProSticks.com

Techniques


Figure 4. USD/JPY ProSticks Ichimoku Weekly Chart

Figure 3. USD/JPY ProSticks Ichimoku Daily Chart

Techniques


MARKET TIMING USING THE NYSE BULLISH % by Dominic Hawker

Breadth indicators remain a simple and effective methodfor measuring the strength of a market trend.

For the stock or index fundinvestor, it is important to main-tain a feel for the prevailing mar-

ket conditions. Whether one pursues aregular "buy and hold" or a more spo-radic approach to stock investment,one should always be aware of theinherent risk and potential returns thatthe market has to offer; and yourinvestment strategy should constantlyadapt to meet these conditions.

Market averages such as the DowIndustrials or S&P500 indices are themost readily available barometers formarket conditions. Using charts, it isrelatively straightforward to determinethe index trend and to identify howlong this trend has been in place.However, of more benefit is an under-standing of the underlying strength ofthese market trends as this will go someway to determining the likelihood ofthe trend changing (and the relative lev-els of market risk). Breadth indicatorswere developed precisely with this taskin mind: to determine the strength of amarket trend by looking at the trends ofits constituent stocks.

The NYSE Bullish %The first breadth indicator, the NYSEBullish Percentage, was developed byAbe Cohen, the founder of InvestorsIntelligence in 1955. He was an earlypioneer of point & figure (p&f) stockcharts and these provided the idealbuilding blocks for a market barometer.By recording stock prices, p&f chartseffectively map out the relationship

between demand (buyers) and supply(sellers). The advantage of p&f chartsis that these supply/demand imbal-ances are clear cut and easy to identify:if demand outstrips supply, a p&f bullsignal is generated and if supply out-strips demand a p&f bear signal is gen-erated.

Abe Cohen took the logical leap thatby calculating the percentage of bulltrends amongst the constituent stocksof the NYSE index, he would have anaccurate picture of the supply/demandrelationship for the market as a whole.For example, if there were 2000 stocks

in the NYSE index and 1000 of themwere on bull signals, then the Bullish %would be reading 50%.

As it turned out, not only did theNYSE Bullish % identify periods whenthe bulls were in the driving seat i.e. thebest time to buy stocks, but it alsoproved to be one of the best contraryindicators for calling intermediate mar-ket tops and bottoms.

Using the NYSE Bullish %Probably the best and most commonanalogy applied to the NYSE Bullish %is that of an American football

Figure 1.

→→

Techniques


game, where the level of the bullish %represents the current field positionand the areas above 70% and below30% are the "end-zones" (see Figure 1).

For a basic market strategy, think ofthe play moving from one end-zone tothe other:

Low risk area below 30%: Almosteveryone who wants to sell has alreadysold. Once the "play" starts moving upfrom this area (indicated by reversals on

the p&f chart of the bullish %) it istime to start playing the offense i.e.aggressively buy stocks, even volatiletechnology names and attempt bottom-fishing in stocks at multi-year lows.

Mid-field: When the indicator movesup into mid-field, continue to play theoffense but buy more selectively instocks with strong relative strength.Begin to take profits in recovery playsand holdings with weak relative

strength. Buy new positions on pull-backs.

High risk area above 70%: When the"play" starts moving down from thisarea (indicated by reversals down thep&f chart of the bullish %) it is time toinitiate defensive tactics. Sell any lag-gards (with weak relative strength).Begin to tighten stop loss points on allholdings. Focus new positions in defen-sive/lower beta sectors. Use ETFsinstead of individual stocks to reducevolatility. Buy call options instead ofstock to limit equity exposure.

Signals from the Bullish %Abe Cohen's original strategy for thebullish percentage was to be bullish onreadings above 52% and bearish below48%. However, as time went by, and theback history of breadth data built up,improved applications of this indicatorwere introduced. Earl Blumenthal'sbook "Chart for Profit", published in1975, introduced a series of rules to beapplied to the point & figure chart ofthe NYSE Bullish % or the "BullishBearish index" as he referred to it. Therules were further refined by MikeBurke in 1982, when he became editorof Investors Intelligence, and remain tothis day the recognised method ofapplying breadth to market strategy.

There are seven market conditionsthat can be derived from the p&f chartof the NYSE Bullish % which are asfollows: (See Box 1)

Figure 2 shows the current p&f chartfor the NYSE Bullish %: the chart iscurrently on a buy signal, hence show-ing bull confirmed status for the mar-ket. If the indicator were to movedown below 70% is would move tobear alert status. A move below the pre-vious down column of Os at 50%would be required to move it to bearconfirmed status.

Alternative measurements ofbreadth In the early 1970s, InvestorsIntelligence introduced further breadthindicators that reflected the percentageof stocks above their 10 week (50 day)

Definitions of current market breadth statusBull Confirmed – chart is on a p&f buy signal and is rising (column of x’s); and/or is in a column of x’s above 68%.

Bull Correction – chart is on a p&f buy signal but is falling (column of O’s) without yet reaching 70%.

Bull Alert – chart rising (X’s) moving up from below 30% but has not yet generated a p&f buy.

Bear Confirmed – chart is falling (column O’s) below 70% and has generated a p&f sell.

Bear Correction – chart is on a p&f sell but is rising (column X’s) without having moved above 68%.

Bear Alert – chart is falling from above 70% to below 70% without yet generating a p&f sell.

Bull Top - chart is falling (column of Os) but above 70%.

Box 1.

Figure 2.

Techniques


and 30 week (150 day) moving averages.These indicators provided an alterna-tive method of defining a bull trendand proved to be more sensitive tomarket moves.

Figures 3 and 4 highlight theincreased sensitivity of the NYSE % 10week moving average indicator com-pared to the NYSE Bullish %. Note thesharp down-move that began inJanuary 2005 for the % 10 week indica-tor which has not yet been seen by thebullish %.

Since their introduction, the movingaverage based breadth indicators havebecome the leading indicators, and therole of the bullish % has become oneof a confirming indicator for mediumterm trends.

Applying breadth to otherindicesThe NYSE index, with over 2000 con-stituent stocks, remains a good broad"universe" for measuring general mar-ket breadth. The NYSE bullish % hasnow been calculated for over 50 yearsand in the early days, before the dawnof computers, was calculated usinghand-drawn p&f charts of the con-stituent stocks and adjusting the bullish% figure for changes in the number ofstocks on bull signals. This extensiveback-history provides many precedents

for signals generated in all sorts ofmarket conditions.

The Nasdaq was founded in 1971 asan electronic marketplace for over thecounter (OTC) stocks and rapidlydeveloped as the home for emergingtechnology and growth stocks. Breadthindicators provide an excellent timingtool for this market.

For small cap investors, breadth indi-cators based on the Russell 2000 andValue Line Composite are the mostappropriate tools.

Breadth indicators are also availablefor the S&P indices (Figure 5). This isparticularly useful as a timing tool for"style" investors as one can comparethe breadth indicators for the large

Figure 3.

→→

Figure 4.

Figure 5.

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cap S&P500, S&P Midcap 400 and theS&P Small Cap 600. The S&PComposite 1500 index is a conglomer-ation of stocks from the three indicesand since it covers stocks from theNYSE, AMEX and Nasdaq, provides aviable alternative to the NYSE breadthindicators.

Breadth and ETFsThe introduction of exchange tradedfunds (ETFs) has provided investorswith an efficient vehicle for investing inthe above indices thereby offeringexposure to a diversified basket ofstocks that would be difficult to achieveby direct stock investment. Using thebreadth indicators for the relevant

underlying indices can provide a valu-able tool for the timing of ETF invest-ments.

International marketsInvestors Intelligence regional servicesnow offer breadth indicators coveringmarkets such as the UK (FTSE 100 orFTSE All Share constituents), Europe(the "All Europe" breadth indicatorsmeasure breadth of all major Europeanindex constituents), and Japan (theTopix 100 or Nikkei 225 breadth).

ConclusionThe benefits of breadth indicators lie intheir use as a market risk measurementtool and as a means of tailoring one's

investment strategy to meet the currentrisk/reward characteristics of the mar-ket.

Whilst the Bullish % and otherbreadth indicators were largely devel-oped by the p&f community, we firmlybelieve that this powerful form ofanalysis should appeal to any investorwith market exposure.

Dominic Hawker is European ana-lyst at InvestorsIntelligence.comand a director of StockcubeResearch Limited. The InvestorsIntelligence site displays breadthcharts in a variety of formats for allmajor stock markets.

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Techniques


MEASURING THE STRENGTH OF SUPPORT AND RESISTANCE by Erich Senft

There is a world of differencebetween guessing where themarket might be going and let-

ting the market tell you where it isgoing. Knowing how to handle supportand resistance - price levels at whichexcess supply or demand can beexpected to temporarily halt or evenreverse price direction - is the key.

Since the market tends to move fromone support and resistance level toanother, knowing where these levels aregives us an idea of where the market isheading next. Furthermore, being ableto quantify the strength of support andresistance will give you some guide asto whether price will steam throughthese levels or rebound off them.

Might makes rightThe strength of a support or resistancelevel is determined by how many timesthe market tests that particular price.Each time the price has been hit byeither a high or a low it counts as onepoint towards the strength of theresistance level. The more times a sup-port or resistance area has been testedthe harder it becomes.

Therefore if you have a price that hasbeen tested 5 times as support andanother price that has been tested 3times as resistance, then the market willlikely break through the resistance (3)since it is not as strong as the support(5).

This is a basic premise of trading sup-port and resistance: that all things beingequal, the market will always choose thepath of least resistance. However, fac-tors such as the overall market trend,long term support or resistance andoverbought/oversold status means thatthings are not always equal.

Weighting support & resistanceWhile each occurrence, or "hit", ofsupport and resistance counts as onepoint towards the overall strength ofthe resistance level, some types of sup-port or resistance are stronger thanothers and therefore require specialconsideration. In fact the biggest mis-take traders make is assuming that allsupport and resistance are createdequal. They are not.

Factors such as exact and/or roundnumbers, contract highs and lows aswell as significant retracement levelslike Fibonacci 38%, 50% and 62%retracements all serve to add strengthto support and resistance in question.Generally speaking, I consider such lev-els to increase the strength of theresistance by 50%.

Using the weekly crude chart in

Figure 1 as an example, we can see thatthere are four hits at the high of 55.20(15 October 2004 at 55.00; 22 October2004 at 55.17; 29 October 2004 at55.05; and 4 March 2005 at 55.20).However this resistance does not sim-ply count as 4 hits, rather it is muchstronger than that.

The resistance occurs at the contracthigh, which is a very significant pricebarrier in the life of a commodity. Themarket requires a great deal of momen-tum in order to exceed such a level.Therefore we would add another 50%to the original 4 hits to represent thestrength of the contract high.Therefore our 4 hits have the samestrength as if this price had 6 hits.

Likewise the resistance is occurring atthe neckline of a rounded bottom for-mation. Again the neckline repre-

Figure 1.

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Techniques


Identifying support and resistance isnot quite as difficult as some peoplemake it out to be:

Identifying Support and Resistance

Support or resistance occurs whenyou have two or more highs, lows,opens, closes or combinationthereof, occurring at, or close to,the same price. When the daily val-ues intersect at a particular price,this forms support or resistance.

Consider opening and closingprices along with the highs andlows of each price bar. While thehighs and lows represent the limitsof both the buyers and sellers, theopening and closing prices showprices to which the market is espe-cially sensitive.

Prices form two types of supportand resistance:

1. Exact price resistance - when thehighs and/or lows meet at an exactprice2. Price zone resistance - when thehighs and/or lows are closeenough in price to act as supportor resistance but are not exact.

Because resistance is often in theform of a price zone, many tradersmake the mistake of being too

tight with their support and resist-ance figures.

To determine if prices are "closeenough", look back to see wherethe market has reversed off ofsupport or resistance in the past.By examining how close priceswere when the market reactedbefore, you get a feel for how closeprices need to in the future.

In a market like crude oil forinstance, prices within 10 centswould be considered close enoughto count as resistance. For exama

ple, if we saw May crude trade at49.00 and 49.10, these two priceswould count as two hits on thesame resistance level.

As a rule of thumb, the daily chartparameter is normally doubled forweekly and monthly charts.Therefore if 10 cents is closeenough to count as resistancebetween values on a daily chart,then the criteria would be expand-ed to include values which are 20cents apart on weekly and monthlycharts.

sents a significant resistance barrier andas such we need to add another 50% toour resistance value in order to accu-rately represent its strength. In otherwords our original 4 hits represent thesame strength as if the price had 9 hitson it.

Any support or resistance level thatdoes not score at least a 5 using thismethod is likely not strong enough toaffect the market and can be ignored inyour analysis.

Does this mean that the market has toreverse off these levels? No, it doesnot, but what our support and resist-ance analysis does tell us is what the

market is most likely to do when itapproaches these areas of heavy resist-ance.

We need to consider other factorssuch as the seasonal tendencies of themarket, the strength of the trend, andwhether prices are overbought or over-sold before we can make an accurateprediction as to whether the resistancewill cause a full reversal or merely apause in the trend.

However, knowing that a significantresistance barrier is nearby allows youto better time your market entry orpostpone your entry altogether untilyou can see how prices react to the

resistance in question. Likewise if youare in a trade and see the marketapproaching an important resistancearea you can tighten your exit stops orexit with a profit taking order.

As such, identifying and quantifyingsupport and resistance levels is one ofthe best ways of achieving superiormarket timing and for keeping riskexposure as small as possible. Usingsupport and resistance moves tradingfrom the area of prediction into thefield of management.

Erich Senft, CTA, is director ofwww.supportandresistance.com

Techniques


SWING TRADING WITH FLOAT CHARTSby Steve Woods

Float Charts are the only chartsthat use all four available piecesof stock data: price, volume,

time and the float.The term float refers to the number

of shares actually available for trading.When a company goes public they issueshares outstanding. The managementthen holds some percentage of sharesand what's left over to be sold to thepublic is called the float or floating sup-ply. Float Charts are all about trackingthe floating supply in an attempt to findareas of accumulation and distributionon the chart due to a change in theownership of the floating supply.

There are three other terms that arekey to constructing and analyzing FloatCharts: Float Turnover, Float Boxes,and Float Channel Lines.

Float turnover refers to any timeframe on the chart in which the cumu-lative volume equals the number ofshares in the floating supply. Floatturnovers are shown on the chart as agray rectangle with two red lines. Therectangle changes from day to day like amoving average and is known as theFloat Turnover Box or more simply theFloat Box.

The upper and lower right hand cor-ners of the Float Box get plotted on aday-to-day basis thereby creating FloatChannel Lines. These channel linesallow us to see the "tracks" left behindfrom previous float turnover boxes inthe past. By creating Float Boxes from1/2 or 1/4 of the floating supply weget narrower channel lines within thelarger 100% Float Box Channel lines.These narrower lines known as the50% and 25% float channel lines show

where stocks have a tendency to findsupport at the bottom of corrections.These are the lines that create the ABCFloat Set-Ups.

To understand Float Boxes moreclearly let's study an example of one ofmy best winners in the NovemberElection Rally of 2004 in Figure 1. Atthat time Parlux Fragrances (PARL)had 7.3 million shares in its float. Tocreate its current Float Box we simplyadd today's volume with yesterday'svolume and that total with the volumeof the day before that and continue acumulative sum until the total in thebackward count reaches 7.3 million. Atthe time of this writing, it took 25 daysto trade 7.3 million shares. Thus itsFloat Box is a rectangle going back 25days. The top and bottom line of theFloat Box are created by finding thehighest and lowest price in the back-wards count whichin its current box is$24.92 on the highside and $19.30 onthe low side.

Float Boxeschange from dayto day much like amoving average.The Float Box sizegets recalculatedevery day as thenew volume num-ber is used todetermine how farback the box willextend. Nowthink of the boxmoving to theright and as it does

so imagine the upper right hand andlower right hand corners being plottedon a day-to-day basis. The upper andlower right hand points are thus used tocreate the upper and lower float chan-nel lines.

Now imagine a box that is createdusing half the Float number (or onefourth the number). For ParluxFragrances this would be half of 7.3million or 3.65 million (one fourthwould be 1.83 million). Now imagine asmaller box with its own upper andlower channel lines. These channellines are called the 50% Float ChannelLines because they're created using abox that is 50% the size of the fullFloat Box (or the 25% float channellines if using a value of 25%). Nowtake away the 50% box (or 25% box)but leave the 50% channel lines (or25% line) and you have a Float

Float Charts™ are a new and unique way to track a stock's trading behaviour. Andone profitable way of using them is to look for ABC Float set-ups.

Figure 1.

→→

Techniques


Chart. Figure 1 shows PARL withFloat Box, channel lines and 50% FloatChannel Lines. Note that I've includedthe 50% Float Box for demonstrationpurposes only as ordinarily this box ishidden from view and we only know itis there by the dotted channel lineswhich are its tracks.

What is important at this point is tothink of three different sized boxesmoving forward in time but capable ofmoving backwards as well. Rememberthat as the three Float Boxes move for-ward from one day to the next, theirupper right and lower right hand cor-ners create the channel lines. Movingthe boxes backwards is helpful as itallows you to analyze past price, vol-ume, float and time formations.Currently there is only one piece ofsoftware that allows the box to be freelymoved backwards through time andthat is the V2 Charting software creat-ed by www.StockSharePublishing.com.

One final but important point con-cerning Float Boxes and Float ChannelLines is the method for plotting themon price penetration days. Let's say astock has been trading sideways for sev-eral weeks and the top of the Float Box(the upper red line) is at $25 and thebottom of the Float Box (the bottom

red line) is at $20. Now let's say thestock finally penetrates above the topred line and makes a new high of $27.On this penetration day, we don't wantthe top red line to be placed at the newhigh of $27. If it was placed there,then we wouldn't be able to see that thebreakout had occurred. Instead wewant the line at $25 to remain there sothat a penetration is actually visible.What gets sacrificed is the actual size ofthe Float Box on the day of the pene-tration. The actual size should bebased on the new high that has justbeen reached. Figure 2 illustrates thisimportant point.

ABC Float set upsAny one who takes the time to look ata large number of Float Charts will findone striking discovery that is seen againand again. Prices in up-trends tend tofind support near their 50% or their25% Float Channel Line. It is easiest tosee this on a Float Chart with the FloatBox removed, so let's look at a fewexamples.

I prefer random sample demonstra-tions of Float Charts so I've chosen thefirst three charts that are mentioned inthe table "NASDAQ Where the BigMoney's Flowing" on page B6 of the

Investor's Business Daily on January28th (the day this article was written) -these are Affymetrix (AFFX), DigitalRiver (DRIV), and Websense (WBSN).

Now let's look at their charts and seeif support came in at or near either the50% float channel line or the 25% floatchannel line at any point on the chart.

Affymetrix (AFFX) (Figure 3)From its August 2004 low ($24.48) toits January 2005 high ($41.96)Affymetrix found support right at its25% Float Channel Line twice. Onceon October 12th ($28.89) and once onJanuary 4th ($33.94). Both occasionsmarked the low of the month.

Digital River (DRIV) (Figure 4)From its August 2004 low ($22.75) toits December 2004 high ($44.51)Digital River found support right at its50% Float Channel line once - onNovember 4th ($31.08). This pointmarked the bottom of its deepest cor-rection in its run to the upside.

Websense (WBSN) (Figure 5)From its August 2004 low to itsDecember 2004 high, Websense foundsupport twice just under its 50% floatchannel line.

Figure 2. Figure 3.

Techniques


One striking characteristic of the 50%and 25% Float Channel Lines is theirdynamic quality. It is a mistake to thinkof the 50% lines as being 50% of thedistance between the top and bottomof the 100% Float Box. The channellines have their basis in volume num-bers not prices and can create levelsthat are unrelated to any past pricelevel. Thus the lower 50% float chan-nel line may actually show up near thetop 100% float channel line or the nearthe bottom 100% float channel line. Itall depends on the new volume data,which obviously changes from day today. The fact that prices find supportand resistance at different percentagelevels within the float turnover is one ofthe great discoveries of Float Analysisand needs further explanation.

In order to make money with theseideas, I use a simple ABC price swing.The model is very simple and yet very

powerful. The idea is that prices tendto move in a three-wave sequence: an AWave Up, a B Wave Down, and a CMove Up again. Thus in using thismodel to trade, we let the market showus strength with price and volume inthe A Wave, then we want to see thevolume dry up in the B wave down tothe 50% Float Channel Line and thenjust as the price begins to move back upwe jump on board for a profitable CWave. By using the 50% Float Channelline to help us find the turning pointwhich begins the C Wave, we look forhigh probability entry points. Our dailyand weekly scans find the stocks thatare turning around and heading higherright at or just below the 50% levelwhich is the start of the profitable CWave. We simply buy into the price riseon those stocks that we see as havingthe highest likelihood of continuing tomove on up.

Float Charts are a new and powerfultool in the search for profitable tradingand although they are not as widelyknown, used or understood as othercharting methods, they are an impor-tant development in the history ofcharting.

Steve Woods is a professional traderand CEO of www.FloatCharts.com,an independent stock charting andmarket analysis service based on theideas found in his book FloatAnalysis (Wiley, 2002).

Note: The origin of Float Charts and their analysisgoes back to the writings of W.D. Gann. See Gann,W.D. (1976), Truth of the Stock Tape, Lambert-Gann Publishing, Pomeroy, WA and my book:Woods, Steve (2000) Float Analysis, Wiley & Sons,New York, NY

Figure 4. Figure 5.

“PRICES IN UP-TRENDS TEND TO FIND SUPPORT NEAR THEIR 50%

OR THEIR 25% FLOAT CHANNEL LINE.”

Speakers

Technical Analysis in the FX MarketsTechnical Analysis in the FX Markets is a one day seminar designed to equip traders, hedge funds and fund managers with the most effective charting techniques to trade the FX markets. With contributions from leading market analysts, the event will present a range of studies that will enhance both short and long term trading returns.

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Robin Griffiths is Head of Asset Allocation with Rathbones Investment Management. Robin was previously with HSBC Investment Bank and is one of the financial markets’ best known and most respected technical analysts.

Jason Perl is Global Head of the Fixed Income, Rate and Currencies Technical Strategy Group at UBS Investment Bank. Jason provides trading ideas to the bank’s internal and external customer base and is a specialist on DeMark indicators.

Taso Anastasiou is a Foreign Exchange Technical Analyst at UBS Investment Bank. With over ten years experience in the FX markets as both an analyst and trader his area of expertise is Elliott Wave theory.

Jessica James specialises in foreign exchange research with Citigroup’s FX Risk Advisory Group. She has been at the forefront of development in currency risk management models and has pioneered the use of Extreme Value Theory.

Shaun Downey is Head of Technical Analysis at charting software provider CQG. Shaun provides daily research to CQG clients such as banks and hedge funds and is highly regarded for the reliability of his market forecasts.

Roy Batchelor is HSBC Professor of Banking and Finance at Cass Business School in London. His research focuses on issues in forecasting, risk management and behaviour in financial markets and he regularly conducts seminars on market forecasting.

presents

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Mapping the MarketGaining an edge in the currency markets with intermarket analysisRobin Griffiths, Rathbones Investment Management

Quantifying DivergenceMaximising the value of technical indicators Shaun Downey, CQG

Trend Following StrategiesAre the simplest FX trading strategies still the best? Jessica James, Citigroup

DeMark IndicatorsUsing DeMark to generate clear and profitable buy and sell signals Jason Perl, UBS

Elliott WaveOptimising an Elliott Wave trading strategy Taso Anastasiou, UBS

Behavioural Finance & TAWhat behavioural finance has to offer the FX trader Roy Batchelor, Cass Business School

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TA: What do you do at Standard Life Investments?

MG: I am responsible for currency dealing, position takingand, along with others, the currency strategy for StandardLife Investments funds. Most of what I do is involved withmanaging the currency risk in-house but I also get involvedwith speaking to clients and pitching for new business.

We manage currency risk in different ways depending onthe mandate of certain funds. Some funds only take nakedcurrency risk, some funds are fully hedged and some are ahybrid of both. The currency risk that I am actively manag-ing involves only the major and secondary currencies at themoment.

TA: To what extent do you use TA on a daily basis?

MG: Technical analysis is the bread and butter of my dailyroutine. I pay attention to the market buzz because I believeit is good to know what the market is focusing on, whetherthat is economic figures or other currency related news butfor me, price action is of paramount importance.

The great thing about currencies is that they are driven byall sorts of different factors so a currency specialist has tohave his finger on the pulse of what stocks, bonds andcommodities are doing as well as the political and economicnews. I think this is one reason why technical analysis isvery suited to currencies.

Price action will reflect the consensus of how all thesedifferent factors are being perceived by the market so thatat any one time we can see whether the bulls or the bearsare in control. For me, this is what technical analysis is allabout. It is not about "oneself" being bullish or bearish; it isabout working out who is in control of the market, thebulls or the bears, and managing your risk accordingly.

So, to answer the question, my daily routine involvesusing technical analysis constantly over different time scalesto answer this question.

TA: Which TA techniques and studies do you use on a reg-ular basis?

MG: I am a trend follower and proud of it. It alwaysamazes me how some people disdain the phrase 'trend fol-lowing' because everyone who ever made any money out ofthe markets has done so by following a trend of somedescription. If you are looking for turning points in themarket or even if you base your decisions on fundamentalanalysis then you are doing the same as someone whotrades breakouts. You are looking for a continuation of theprice in the direction you traded!

My preferred method is based on the Alexander Eldermultiple timeframe method whereby you establish the longterm trend first and then trade one timeframe down in thedirection of that trend. So I will measure the long termtrend based on weekly moving averages and the short termmomentum based on the daily MACD. If the long termtrend is up then I am only looking for MACD buy signalsand vice versa if the long term trend is down. I will alter

THE TECHNICAL ANALYST TALKS TO…

Interview


Murray Gunn

Murray Gunn is investment director ofcurrencies within the Treasury division atStandard Life Investments in Edinburgh.He has also worked as a bond and currencystrategist at Standard Life and was previouslya fund manager with Hambros in London.

Interview


my position size based on the position of the MACD oscil-lator and a volatility measure.

I prefer this type of non-continuous trend followingmethod to one where you are in the market all the timebecause, although you will make money over the long termusing that method, you could also get chopped to death bynon-trending market conditions.

The drawback with this method is that you could misssome big opportunities when the long term trend is in theprocess of turning. For this reason I also look for diver-gences between price and MACD. So if the long term trendis currently up but the daily MACD has given a sell signal,whereas normally I would ignore this sell signal, if it is alsoexhibiting bearish divergence then I go short. This shouldmean that I am covered if the daily divergence leads to aturn in the long term trend.

TA: Do you make any distinction between short-term andlong-term analysis?

MG: The method I’ve just described makes use of long andshort term analysis. I think this is possible if you are using amechanical or semi-mechanical process but I think itbecomes more difficult when using discretionary techniquessuch as pattern recognition. For example, if the weeklychart is showing a double bottom but the daily chart isshowing a double top what do you do? In my experienceyou can end up with too much confusion. I prefer to stickwith one time frame if I look at discretionary technicalanalysis techniques but I will use multiple time frames formore mechanical techniques.

TA: How much do you consider fundamentals?

MG: At the currency overlay or active currency manage-ment level our approach is to manage the risk based onstyle diversification and risk budgeting. So my colleaguewho is more fundamentally based will manage some riskbased on that style and I will manage some risk based solelyon technical analysis. This approach works well becauseeach style is relatively uncorrelated. As we know, when thetechnicals are bullish then the fundamentals can be bearishand vice versa. Style diversification is a way of recognisingthis and is a prudent method of risk management at theportfolio level.

TA: Which software do you use?

MG: I use Bloomberg generally and TradeStation forresearch and testing.

TA: How many at SLI are using or are involved with TAeither on the FX, fixed income or equity side?

MG: There are a number of people across the companywho have an active interest in, and use, technical analysis

techniques. Indeed, our strategy desk use it as an importantinput into our house view process for asset allocation.Generally, most asset classes will use technical analysis (or atleast a recognition of price action) in their investment deci-sions. It fits well with our Focus On Change investmentprocess at SLI because we are constantly asking ourselvesquestions to find market drivers and market triggers.

TA: Are there any technical analysts that you admire in par-ticular and any publications that you rely on?

MG: Early on in my career when I was at Hambros I satnext to Tony Plummer who influenced me greatly. His aca-demic approach has kept me interested in the theoreticalaspects of technical analysis. I'm always interested in whatRichard Russell has to say on Dow Theory given his vastexperience and I listen to what Robert Prechter has to sayon long term Elliott Wave theory. I also admire the work ofRedtower Research, based here in Scotland.

TA: Are there are any recent developments in TA that haveinterested you?

MG: I think the work done by Michael Covel at TrendFollowing is interesting. He brings the subject much moreinto the open and dispels some myths about hedge fund"black boxes". I think the investing public will be amazedby how such superb long term returns have been generatedby such a simple technique. I am also very interested in theSocionomics Foundation that Robert Prechter has set up tofurther research into social trends because this whole sub-ject is what links technical and fundamental analysis togeth-er.

TA: Does being located outside the City of London makeany difference to the acceptance and use of TA? For exam-ple, is TA less widely used in the financial district inEdinburgh than in London?

MG: One of the best aspects about using technical analysisis that it doesn't matter where you are based as all a techni-cal analyst needs to know is the objective data. We have anumber of members of The Society of Technical Analystsin Scotland and we meet up from time to time to discussour techniques and research.

The Scots financial community tends to be more biasedtowards fundamental analysis although there are pockets ofpeople that use technical analysis a lot. I think there is still aview that technical analysis is useful only for the short termand this is one reason why it has difficulty being acceptedfully by long-term investors. It is up to us as technical ana-lysts to point out that market psychology is just as relevantfor long term investing as it is for shorter term trading.

Subject Matters


NEW THEORETICAL LIGHT FOR TECHNICAL ANALYSIS by Kian-Ping Lim

Does technical analysis have any solid theoretical foundation in the academic literature? The author argues in favour of an important new theory to underpin TA -Adaptive Markets Hypothesis.

The Efficient MarketsHypothesis (EMH) has beenthe guiding light in the field of

economics and finance for the past fewdecades. So much so that any findingsthat contradict it have been dismissedas statistical anomalies.

Yet the theory no longer receivesresounding acceptance among sea-soned practitioners who continue toexplore ways to exploit predictabilitiesin the stock markets. One of the tech-niques widely employed by profession-als in the investment world is technicalanalysis - a practice dismissed by disci-ples of EMH who hold on to the beliefthat patterns observed in the pastoccurred by chance.

In recent years, the pendulum hasswung in favour of professional ana-lysts with more and more evidence ofstock market predictability beingreported in the academic literature. Infact, in 1999, John Cochrane, professorof finance at the University of Chicago,labeled stock market predictability a'new fact in finance'.

The search for a theoretical explana-tion for predictable patterns has been achallenging one. Up to now, the field ofbehavioural finance has been most suc-cessful in providing plausible explana-tions, to the extent that behaviouralfinance has proved a natural academically for technical analysis. It now seemsnormal to marry the two together withthe idea that charts are the graphicalrepresentation of market psychology.

However, EMH still survives. This is

because evidence reported in the aca-demic literature does not lean cleanlytowards either side - behavioural orclassical economics - and this has fur-ther hardened the resolve of propo-nents on both sides.

In an article that appeared in theSeptember/October issue of TheTechnical Analyst, I attempted to offerreconciliation to the controversybetween proponents of EMH andadvocates of technical analysis. Usingdaily data of South Asian stock marketindices, I demonstrated that there weretimes when the markets moved ran-domly and other times when the mar-ket moved in a significantly non-ran-dom and dependent pattern. In thisregard, during those periods when themarkets moved non-randomly, it waspossible for investors to devise a trad-ing rule to exploit these linear and non-linear dependencies to earn abnormalrates of return.

The statistical exercise I carried outrevealed that the mixed evidence onefficiency/ inefficiency documented inthe academic literature was not surpris-ing. I found that there were times whenthe market was efficient and timeswhen the market was predictable. Usingthe same analysis on the same market, itcould be seen that different time peri-ods gave contrasting results. The mainmessage that emerged was the impor-tance of market timing strategies, sincepredictability is mainly a short-horizonphenomenon with predictable patternsappearing only sporadically.

Though my work threw importantlight on the controversy between EMHand technical analysis, it lacked anysolid theoretical framework to justifythe findings. But subsequent to mystudy, a new theory has emerged thatfills this theoretical void - the "AdaptiveMarkets Hypothesis" (AMH), pro-posed last year by Andrew Lo, profes-sor at MIT Sloan School ofManagement. The potential impor-tance of this theory was underlined byits publication in a special 30th anniver-sary issue of the Journal of PortfolioManagement.

The theory is heavily influenced byrecent advances in the emerging disci-pline of "evolutionary psychology".This new paradigm, which is an alterna-tive to the classical EMH, is based onthe principle of evolution where com-petition, adaptation and natural selec-tion determine the efficiency of mar-kets and the waxing and waning offinancial institutions, investment prod-ucts, and ultimately individual fortunes.

AMH offers a number of concreteimplications for the practice of portfo-lio management. Firstly, contrary toclassical EMH, profit opportunities doarise from time to time in AMH. Thevery existence of active liquid stockmarkets implies that profit opportuni-ties must be present. This is not sur-prising - researchers have long arguedthat perfectly efficient markets are animpossibility, for if a market is perfect-ly efficient, there is no profit earned byinformation gathering, in which case


Subject Matters

there would be little reason to trade andmarkets would eventually collapse.

Thus, in practice, there must be suffi-cient profit opportunities to compen-sate investors for the cost of tradingand information gather-ing. From an evolution-ary perspective, thesepredictable patternsshould not persist overtime because they willdisappear after identifica-tion and exploitation byinvestors, but newopportunities are contin-ually being created asgroups of market partic-ipants, institutions andbusiness conditions allchange.Lo presents an illustra-tion of this process:

"…those investorswho experienced sub-stantial losses in the tech-nology bubble are morelikely to have exited themarket, leaving amarkedly different popu-lation of investors todaythan four years ago.Through the forces ofnatural selection, historymatters."

Hence, contrary to theinexorable trend towardshigher efficiency as pre-dicted by classical EMH,AMH implies consider-ably more complex mar-ket dynamics, withcycles, trends, panics,manias, bubbles, crashes,and other phenomenathat are routinely witnessed in naturalmarket ecologies.

To support his point, Lo computedthe rolling first-order autocorrelationof monthly returns of the S&PComposite Index from 1871 to 2003, amethod for determining how muchinterdependency there is in a priceseries. According to classical EMH, thefirst-order autocorrelation coefficientswere expected to take on larger values

during the early part of the sample andbecome progressively smaller in recentyears as the US equity market becamemore efficient. Against the expectationof EMH, the graphical plot instead

demonstrated that the degree of effi-ciency varied through time in a cyclicalfashion, with the surprising result thatthe market was more efficient in the1950's than in the early 1990's - a find-ing consistent with AMH.

Moreover, it's possible that Lo him-self underestimates the level of pre-dictability in prices. His study assumesthat a lack of autocorrelation means aprice series is unpredictable, yet the

method he employs is only capable ofdetecting linear dependencies. In thisregard, the (windowed-testing) proce-dure that I and others have used issuperior because it can also uncover

non-linear dependencies- this is the statisticalequivalent of being ableto spot chart formationssuch as head-and-shoul-ders.

Secondly, investmentstrategies will wax andwane, performing well incertain environmentsand performing poorly inothers. Specifically, AMHimplies that investmentstrategies undergo cyclesof profitability and loss-es in response to chang-ing business conditions,the number of competi-tors entering and exitingthe industry, and the typeand magnitude of profitopportunities available.

As such, the AdaptiveMarkets Hypothesis pro-vides a solid theoreticalbasis to explain whythere appears to be timeswhen technical analysisworks and times when itdoes not. This calls foractive managementstrategies and justifiesthe application of techni-cal techniques in stockmarket investment - thesuccess of whichdepends on the ability totime the market.

AMH could well be thetheoretical foundation that technicalanalysis has been missing. Only timewill tell whether it can make importantinroads into the financial mainstream.

Kian-Ping Lim is a lecturer in theLabuan School of InternationalBusiness and Finance, UniversitiMalaysia Sabah, Malaysia.

Financial institutions are forever striving for moreflexibility from technical analysis software solutions.Here we present two of TraderMade's latest productreleases that have been designed to meet thesedemands - The Cube and TraderMade404.

The CubeIn an ideal world, dealers can sit at any desk within thedealing room and have access to all of their applicationsand personal settings. Portability and flexibility is what isrequired, but this really means using browser-based appli-cations. However, the problem with such web-based tech-nical analysis systems is that they have simply not been upto the specification required by institutional users.

TraderMade, a UK company that has been providingtechnical analysis solutions to the financial markets since1985, has finally bridged that gap with a brand new prod-uct called The Cube.

As its name suggests, The Cube has been designed as acontainer for whatever market information you want todisplay. The package includes customizable quote boards,news, plus comprehensive technical analysis studies. Theseinclude:

Each user can construct and save their pages exactly howthey wish. They can then access the application and theirsettings from any internet PC in the world.

Since The Cube is a java applet accessed through viainternet, it requires no software installation and can run onany internet PC. This also makes it an ideal low-cost solu-tion for disaster recovery provision.

One potential issue is that, in the fast moving world ofJava programming, Java applications can clash with eachother when using different Java plug-in versions.TraderMade has solved this issue and can support theapplication running in a multiple Java plug-in environ-ment.

As well as designing the analytical front-end,TraderMade also provides the raw data, covering all the

major asset classes (bonds, futures, FX, commodities,deposits, stock indices and shares). All of this data hasbeen checked and cleaned so that the charts are completeand accurate, free from spikes and gaps, with more than 20years of back data available for most instruments.

Clean data ought to be a given in this day and age, butmany TA systems continue to be badly let down in thisarea. But even if you want to keep to your existing dataprovider, The Cube allows you to incorporate your ownmarket data or news feeds, effectively using the front-endproduct only.

In summary, The Cube offers a high level analytics package in aflexible, portable web-based application.

TraderMade404TraderMade404 replaces the existing TraderMadeWorkstation range. With additional functionality and newoptional services, the 404 fulfills the requirements of themost demanding of TA users.

TraderMade404 is available in five different levels. Whilethe 404 Lite offers an abundance of TA tools, users canupgrade to Standard, Intermediate, Advanced orProfessional levels to fit their exact needs and budget. Butdespite this depth of functionality, the product is remark-ably easy to use.

At the most basic level, users can build and save unlim-ited chart pages. Most actions can be performed usingdrop-down menus, button bars or the keyboard, so userscan choose their favorite method of getting around the

TRADERMADE404 & THE CUBE


Software

Moving Averages, Bollinger Bands, Parabolics andWeekly Rules.RSI, Slow Stochastics, MACD and DMI.Extensive line drawing options, including channels,Fibonacci retracements and fans.

Software

system.TraderMade's Microsoft Certified Partner status has

allowed them to structure the product with familiar func-tions and actions such as copying and pasting charts orlinking data feeds to Excel.

At the top of the range, the 404 Professional offerssome important extras for the advanced user. Theseinclude:

Although TraderMade has traditionally been perceived asa tool primarily for the FX markets, the 404 offers

enhanced features and data manipulation particularlydesigned for futures users. This includes flexible contractrollover dates for continuation charts; default front, 2nd,3rd-month contracts etc.; volume indicators; and spreadsand butterflies - giving a truly bank-wide solution for mar-ket analytics.

With regard to data, the 404 feeds off the sameTraderMade databases as The Cube and therefore offersthe same advantages that come with good quality cleandata. However, recognising the fact that the breadth ofTraderMade's databases may be insufficient for some insti-tutions, external data sources can be fed into the 404instead (as is also the case for The Cube).

Institutional users who regularly communicate withexternal clients (or other dealers) may also wish to add-onTraderMade WebLink. WebLink enables analysts to broad-cast their charts and opinions to clients in real-time withall charts up-to-date and time-stamped - an important toolfor presenting consistent information both in-house andto external customers.

In summary, TraderMade offers a full suite of charting products,from specialized high-end applications to white label solutions forlarge audiences, all fed by the same high-quality data feeds. Whileoffering something for everyone, TraderMade expects The Cube andTraderMade404 to make a significant impact in the market over thecoming months.

Paddy Osborn is a director of TraderMadeInternational.

Programming - The ability to build your own analyticaltools. Fully programmable in VB Script, the 404 can beused to manipulate TraderMade's historical database.Proprietary models can be constructed within the sys-tem or copied from Excel spreadsheets. The results canthen be displayed on a chart to illustrate the profitabil-ity of any particular model. For an additional cost,TraderMade also offers programming solutions for you.

Data Download - unlimited access to the TraderMadeproprietary database, allowing downloads of data as farback as 1981.

Short-Term Trend Indicator - This is an intra-day pro-prietary trading model which has been generating prof-itable returns in the four major US Dollar crosses forover 15 years. It holds no overnight positions, but getsinto the market as soon as a trend is detected each day.

"UP UNTIL NOW, PROVIDERS HAVENOT BEEN ABLE TO TRANSLATE THEIR

SOFTWARE APPLICATIONS TO THEINTERNET WITH ANY GREAT

SUCCESS. THE CUBE IS THE FIRSTPRODUCT TO CRACK THIS DILEMMA."

PADDY OSBORN, TRADERMADE


Book Review

The Psychology of the Foreign Exchange Market

By Thomas OberlechnerJohn Wiley & Sons Ltd258 pages, £45.00ISBN 0-470-84406-X

The Psychology of the ForeignExchange Market is available fromthe Technical Analyst bookshop atthe reduced price of £31.50 plus£2.00 P+P. To order please call01730 233870 and quote "TheTechnical Analyst magazine".Books are usually posted withinone working day of your order.

Foreign exchange traders are likely to talk about the market in terms of their lover,an ocean and a war zone, says Thomas Oberlechner, professor of psychology atWebster University, Austria.

If this is a surprise to you - and if you still believe traders act as the rational "agents"assumed by classical economic theory - then you'll find plenty more to astound you inthe rest of "The Psychology of the Foreign Exchange Markets".

If not, then expect to see the following recipe: Take two surveys (of 791 FX tradersand 75 financial journalists), shoehorn mixture into popular behavioural finance cake tin,bake in a medium oven for 200 odd pages, and cover with icing made of academic rigourand scrutiny.

The good news is that once you come to terms with the sense that the author hasforced the facts to fit current theory, there are enough gems in there to keep you readingon.

The findings from his surveys are well organised and vividly illustrated; and the resultsare discussed with reference to many interesting psychology experiments. For example,the idea of herding is illustrated by an experiment where nine participants were asked tomatch the length of an original line to one of three comparison lines, two of which wereclearly the wrong length. They were then asked, in turn and in front of the others, tochoose the correct comparison line. What the ninth person didn't know was that theother eight participants were told to give the wrong judgment. The ninth person duly fol-lowed with an incorrect answer; despite the fact the right answer was obvious.

Such experimental examples are entertaining and insightful about human nature. ButOberlechner's conclusions are vague and sometimes even stunted, and you are left tryingto puzzle whether all this will be any help to you as a trader. Part of the problem comesfrom the fact that Oberlechner finds it hard to move on - even on page 192 he is still try-ing to persuade us of something that he already persuaded us of seven chapters ago, i.e.that economic models cannot successfully explain the FX markets.

The chapter on "Expectations in the Foreign Exchange Market" is particularly goodfor anyone trying to demonstrate the widespread use of technical analysis as a forecast-ing and trading tool. His survey showed that on a scale of 1 to 10 where 1 equals the useof pure TA and 10 equals the use of pure fundamental analysis, traders on average gavea ranking of 3.47 for intraday trading, 3.77 for one week, 4.40 for one month, rising to6.79 for over one year.

Also of interest, although not much of a surprise, are his findings about the extent towhich fundamentals and technicals are combined. Oberlechner's European surveyreveals that over 60% of traders use fundamental and technical analysis in pretty muchequal proportion, with rankings of 5 and 6. The number of FX traders mixing bothforms of analysis rises to 87% when rankings 4 and 7 are added. This underlies theimportance of technical analysis to the FX markets and the fact that most traders ignorepurist notions.

Oberlechner, however, makes little attempt to investigate the link between technicalanalysis and behavioural finance, and gives little room to the idea that technical analysisis a way of using the psychology of the markets to trade.

Above all, the book serves two purposes very well. First, as a unique survey of profes-sional FX traders' attitudes and motives and, second, as a literature review of the variouspsychological biases that impact on trading behaviour. It will therefore appeal to manylooking at the market from the outside or even those involved with hiring traders, whomay find something useful in the chapter on "Personality Psychology of Traders". Fortraders themselves, however, it's a shame that Oberlechner couldn't move beyond thesquabble between psychology and economics.

THE PSYCHOLOGY OF THE FOREIGN EXCHANGE MARKET


The CubeThe browser-based

Market Data Solution.

Real-time Data, News, Analytics, charts and the TraderMade database available globally 24/7, fully customisable by you.

Contact us at:

tel: +44 (0)20 8313 0992

email: [email protected]


Commitments of Traders Report

COMMITMENTS OF TRADERS REPORT3 February 2004 - 1 March 2005 Futures only (open interest) non-commercial net long positions and spot rates

10-year US Treasury Source: CBOT

Dow Jones Industrial Average Source: CBOT

5-year US Treasury Source: CBOT

Swiss franc Source: CME

Pound sterling Source: CME Yen Source: CME

-250000

-200000

-150000

-100000

-50000

0

50000

100000

150000

200000

02/03/2004 25/05/2004 17/08/2004 09/11/2004 01/02/2005

3.00

3.20

3.40

3.60

3.80

4.00

4.20

4.40

4.60

4.80

5.00Non-commercial net long

Spot

-100000

-50000

0

50000

100000

150000

200000

250000

300000

02/03/2004 25/05/2004 17/08/2004 09/11/2004 01/02/2005

2.00

2.50

3.00

3.50

4.00

4.50

Non-commercial net long

Spot

-10000

-5000

0

5000

10000

15000

02/03/2004 25/05/2004 17/08/2004 09/11/2004 01/02/2005

9400

9600

9800

10000

10200

10400

10600

10800

11000


Spot

-30000

-20000

-10000

0

10000

20000

30000

40000

50000

02/03/2004 25/05/2004 17/08/2004 23/11/2004 15/02/2005

1.10

1.15

1.20

1.25

1.30

1.35

Non commercial net-long

Spot

-10000

-5000

0

5000

10000

15000

20000

25000

30000

35000

40000

45000

02/03/2004 25/05/2004 17/08/2004 09/11/2004 01/02/2005

1.70

1.75

1.80

1.85

1.90

1.95

2.00


Spot

-40000

-30000

-20000

-10000

0

10000

20000

30000

40000

50000

02/03/2004 25/05/2004 17/08/2004 09/11/2004 01/02/2005

100

102

104

106

108

110

112

114

116Non-commercial net long

Spot


Commitments of Traders Report

Euro Source: CME

Nasdaq Source: CME

3-month eurodollar Source: CME

Nikkei Source: CME

Gold Source: CEI US dollar index Source: NYCE

-20000

-15000

-10000

-5000

0

5000

10000

02/03/2004 25/05/2004 17/08/2004 09/11/2004 01/02/2005

104

106

108

110

112

114

116

118

120


Spot

-800000

-600000

-400000

-200000

0

200000

400000

600000

02/03/2004 25/05/2004 17/08/2004 09/11/2004 01/02/2005

0.00

0.50

1.00

1.50

2.00

2.50

3.00

3.50


Spot

-25000

-20000

-15000

-10000

-5000

0

5000

10000

15000

02/03/2004 25/05/2004 17/08/2004 09/11/2004 01/02/2005

1000

1200

1400

1600

1800

2000

2200

2400


Spot

-6000

-4000

-2000

0

2000

4000

6000

8000

10000

02/03/2004 25/05/2004 17/08/2004 09/11/2004 01/02/2005

10000

10500

11000

11500

12000

12500


Spot

0

20000

40000

60000

80000

100000

120000

140000

160000

02/03/2004 25/05/2004 17/08/2004 09/11/2004 01/02/2005

300

320

340

360

380

400

420

440

460

480


Spot

-15000

-10000

-5000

0

5000

10000

02/03/2004 25/05/2004 17/08/2004 09/11/2004 01/02/2005

102

104

106

108

110

112

114

116

118

120Non-commercial net long

Spot

Long-Term Technicals


LONG-TERM TECHNICALS

Provided by Thomas Anthonj, ABN Amro, Amsterdam

Stalling right under the projected target zone for a potential 5thwave top (1.9566-88) and breaking below the last major top at1.8771 we could be due for a much bigger setback. But unless themarket breaks below trendline support at 1.8575 on a weekly closewe have no confirmation for a bigger setback or reversal yet.Above, the resumption of the up-trend is still favored, but for furtherconfirmation the market has to clear decisive Fibonacci-resistanceat 1.9305.

GBP-USD

Forming almost a double bottom close to the historic 101.25 low, therebound is still too small to argue for a reversal of the bigger bear-trend. As long as the market doesn't exceed massive resistancebetween 107.03 and 108.75 we expect renewed weakness and final-ly a break below 101.25. Thereunder, the downside would be prettyopen towards the head-and-shoulders target at 95.75. A break above108.75 would on the other hand call for another test of necklineresistance at 114.78. It would require a break above the latter toconfirm a long-term up-trend.

USD-JPY

Stalling right around a projected Fibonacci-target for a 5th wave top(1.3650), the market could have started a setback with a minimumdown-potential of 1.1760 (bottom of wave 4). But looking at the com-plex consolidation structure between April and August 2004 there isstill a good chance that the latest setback has only been a minor onewithin a still intact bull-trend targeting 1.3804/1.3921 (Fib projections)and 1.4160 (historic top). If, however, the weekly trendline support at1.2695 is taken out then we can expect a test of the breakout areaat 1.2461, which looks to be the last resort for the bulls.

EUR-USD

There is slightly more room to the upside to at least test trend chan-nel resistance at 54.45 and the calculated target zone for a 3rd waveimpulse at 57.19-58.64. A failure to reach any of these targets wouldonly be indicated once the market breaks decisively below 46.88(38.2 % of the last advance). Such a break would most likely triggeranother correction into the area 41.36 to 37.77/00 from where anoth-er advance to new highs would be expected. Only a break below37.00 to 35.50 would start reversing the bigger up-trend.

Brent Crude


Long-Term Technicals

Having spent months in some kind of sideways consolidation, themarket looks like it wants to break out of an inverted head-and-shoulders reversal pattern. This would give a target of 16800 oncethe neckline is broken. We are still running a fairly high risk of miss-ing the right shoulder however and that would then imply anotherdecline to 9383. A break below 11452 would break the row of higherlows and give the first warning signal. A decisive break above 12200would on the other hand only leave minor resistance at 12788 beforethe upside is wide open.

Nikkei

Exceeding the head-and-shoulders target (10860) has not put us onthe safe side yet as the market is still trading in the target zone for apotential 5-wave cycle up between 11036 and 11400. The risk ofperforming a 2nd wave setback is still fairly high so a close belowtrendline support at 10227 should be taken very seriously. Such abreak could be the trigger to retrace 61.8 % or 76.4 % of the wholeadvance from 7197. A straight break above 11350/400 would on theother hand give room to extend the upside to 11750 (old top) fromwhere we could experience a bigger setback.

Dow Jones

We clearly have to expect a bigger 2nd wave setback that couldeasily erase 61.8 % or 76.4 % of the gains seen since October 02.It would, however, still take a weekly close below trendline supportat 1924 to trigger a bigger decline towards 1522 (61.8 %) or1387/64 (old low/76.4 %) and to then form the right shoulder of abigger inverted head-and-shoulders reversal pattern. Only a breakabove 2328 would re-open the upside for substantial gains towards2400/53 (Fibonacci-projections) or 2646 (38.2 %).

Nasdaq

Still grinding its way up we are on the alert for the first signs of weak-ness. The market has reached a Fibonacci-target cluster for a poten-tial 5th wave up at 1226/53 that could complete the accumulationphase. But unless it closes below weekly trendline support at 1157we have no evidence to argue for a bigger setback. A close belowtrendline support would be worrying and could trigger a setback to954/45 or to 886/77 at worst. On the other hand, to delay the perma-nent risk of a bigger setback (wave 2) the market would have to clearstrong resistance between 1246 and 1298.

S&P 500


9MARCH

Event:STA Meeting

Organiser: Society of Technical Analysts

Contact: [email protected]

13APRIL

Event:STA Meeting



11MAY

Event:STA Meeting



12MAY

Event:The Technical Analyst seminar

Organiser: The Technical Analyst


26-28MAY

Event:ACI 44th World Congress,

Stockholm

Organiser: The ACI


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IN 2005

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TRAINING AND EVENTS DIARY

Training and Events Diary

World Investment StrategyGlobal Report

Robin Griffiths ›Head of Asset Allocation

World Investment Strategy

March issueavailable soon...

To order your copy Please contact Julie WilliamsRathbone Investment Management Limited159 New Bond Street London W1S 2UDUnited Kingdom

Tel: +44 (0)20 7399 0000 Fax: +44 (0)20 7399 0055email: [email protected]

Rathbone Investment Management Limited is authorised and regulated by the Financial Services Authority.

In this February issue...UKFair winds and flood tide 09

EuropeFriends and relations 10

USARed rag to a bull 12

JapanThe benefit of the doubt 14

2005February

Documents

THE MORNING STAR - The Technical Analyst · charting technique from Japan GBP/USD Will defences hold? Jerry Ficchi, senior technical analyst at Brown Brothers Harriman, marks out