Stock market trends: the

behaviour of a chartist
By Enrico Grassi
The various graphical representations help the trader
depict certain “reliable” patterns to help him make
better trading decisions.
There are many graphical formations but there is one
that is particularly reliable and that is generated time
over time, over long periods as well as short periods, it
is the head and shoulders formation
The head and shoulders formation can be bullish or bearish,
it’s typical formation is the following
 

BULLISH

BEARISH
Let us examine the bearish formation in detail:

head r.shoulder
l.shoulder

neckline

the neckline may be horizontal as in the figure or ascending /

descending, the shoulders may be at the same price level or at
different levels, these variations to respect to the typical formation
gives the trader additional information as to the degree of
probability that the formation will follow up with a break through,
i.e. a descending neckline as well as a lower right shoulder raises the
probability of a successful pattern formation, on the other hand an
ascending neckline as well as a higher right shoulder decreases the
probability of a successful formation.
In his book “ The Psychology of Technical Analysis” Tony Plummer
traces a theory that tries to explain the origin of the pattern as a
consequence of natural non linear dynamic systems due to the negative
feed back loops. The mutual development between a system and the
environment involves an interesting and important concept of co-
evolution. The first works on the subject are due to Vito Volterra 1926
and continued by Alfred Lotka in 1956, the theory was further developed
by biologists Paul Ehrlich and Peter Raven in 1965.
The market place can be viewed as an eternal battle between to crowds
of people: the bullish crowd and the bearish crowd. If the bull crowd is
in majority the market is under buying pressure and prices rise, if the
bears are in majority the market is under selling pressure and prices
decline. The battle between bulls and bears is similar to that of predators
and prey in nature. The two crowds participate in a cycle that can be
represented as follows:
 
 A
bulls

B
D

bears
C

The diagram represents a limit cycle and helps us see the relationship
between the two crowds in A we have the max of the bull crowd, in B
the bull crowd is dropping and the bear crowd is gaining, in C the bear
crowd has reached its climax as the bull crowd has reached its min., in D
bull crowd is growing again as the bear crowd declines.
Similar is the diagram between prices and sentiment of the market
players.
 
 

A
price

D B

sentiment

In A we have high prices and sentiment has still little to grow, In B both
prices a sentiment are dropping, in C prices are at a low as sentiment has
still some more to go down, in D prices are picking up quickly as
sentiment follows.
This sort of cycle would produce a stabile price oscillation in
time, it is the action of shocks to the system which generate the
head and shoulder formation. Shocks accelerate the ascending
and descending stages, the system reacts to the shocks as to re-
establish the main cycle, in the phase diagram spirals are
generated ( Plummer assumes golden ratio spirals and so
connects the process to Fibonacci series).
Let us trace the cycle in a price –sentiment frame and see how
the head and shoulder formation generates.
 

price

sentiment
Let us now search for the head and shoulders
formation in a real market situation.We will see how
the formation changes as we go through different
charting techniques, precisely:
1.Line chart
2.Bar chart
3.Candlestick chart
4.Equivolume chart
5.Candlevolume chart
6.Three line break chart
7.Kagi chart
8.Renko chart
9.Point & figure chart
LINE CHART
 A line chart is the simplest type of chart. One price
(typically the close) is plotted for each time period (i.e.,
day, week, month, etc.). A single, unbroken line connects
each of these price points.
BAR CHART
CANDLESTICK CHART
The Japanese developed a method of technical analysis in the 1600s
to analyze the price of rice contracts. This technique is called
Candlestick charting.
Candlestick charts display the open, high, low, and closing prices in
a format similar to a modern-day bar-chart. Articles written by
Steven Nison that explain Candlestick charting appeared in the
December, 1989 and April, 1990 issues of Futures Magazine. The
definitive book on the subject is Japanese Candlestick Charting
Techniques also by Steve Nison (see Suggested Reading).
Some investors are attracted to Candlestick charts by their
mystique--maybe they are the "long forgotten Asian secret" to
investment analysis. Other investors may be turned-off by their
mystique. Regardless of your feelings about the mystique of
Candlestick charting, we strongly encourage you to explore their
use. Candlestick charts dramatically illustrate supply/demand
concepts defined by classical technical analysis theories.
EQUIVOLUME CHART
Developed by Richard W. Arms, Jr., and explained in his book
Volume Cycles in the Stock Market (see Suggested Reading),
Equivolume presents a highly informative picture of market activity
for stocks, futures, and indices.
Equivolume departs from other charting methods with its emphasis on
volume as an equal partner with price. Instead of being displayed as an
"afterthought" on the lower margin of a chart, volume is combined
with price in a two-dimensional box. The top line of the box is the
high for the period and the bottom line is the low for the period. The
width of the box is the unique feature of Equivolume charting; it
represents the volume of trading for the period.

The width of the box is controlled by a normalized volume value. The

volume for an individual box is normalized by dividing the actual
volume for the period by the total of all volume displayed on the chart.
Therefore, the width of each Equivolume box is based on a percentage
of total volume, with the total of all percentages equaling 100.
The resulting charts represent an important departure from all
other analytical methods, in that time becomes less important than
volume in analyzing price moves. It suggests that each movement
is a function of the number of shares or contracts changing hands
rather than the amount of time elapsed.

Perhaps the Equivolume charting method is best summed up by

the developer himself as follows: "If the market wore a
wristwatch, it would be divided into shares, not hours."
CANDLE VOLUME CHART
THREE LINE BREAK CHART
Three Line Break charts originate from Japan and were introduced to
the western world by Steve Nison (a well-known authority on the
Candlestick charting method). The Three Line Break charting method
gets its name from the default number of line blocks typically used.
Using the closing price, a new white block is added in a new column if
the previous high price is exceeded. A new black block is drawn if the
close makes a new low. If there is neither a new high or low, nothing
is drawn.

With a default Three Line Break, if a rally is powerful enough to form

three consecutive white blocks, then the low of the last three white
blocks must be exceeded before a black block is drawn. If a sell-off is
powerful enough to form three consecutive black blocks, then the high
of the last three black blocks must be exceeded before a white block is
drawn.
To draw line break blocks, today's close is compared to the high and low of the
previous block. A block is drawn only when today's close exceeds the high or low
of the previous block. If today's close is higher than the top of the previous block,
a new white block is drawn in the next column from the prior high to the new high
price. If today's close is lower than the bottom of the previous block, a new black
block is drawn in the next column from the prior low to the new low price. If the
close fails to move outside the range of the previous blocks high or low, then
nothing is drawn.

With the default Three Line Break chart, a downside reversal (i.e., white blocks
change to black blocks) occurs when the price moves under the lowest price of the
last three consecutive white blocks. A black reversal block is drawn from the
bottom of the highest white block to the new price. An upside reversal (i.e., black
blocks change to white blocks) occurs when the price moves above the highest
price of the last three consecutive black blocks. A white reversal block is drawn
from the top of the lowest black block to the new high price.
KAGI CHART
Kagi charts are thought to have been created around the
time the Japanese stock market started trading in the
1870s. Kagi charts were introduced to the western
world by Steve Nison (a well-known authority on the
Candlestick charting method). Kagi charts display a
series of connecting vertical lines where the thickness
and direction of the lines are dependent on the price
action. If closing prices continue to move in the
direction of the prior vertical Kagi line, that line is
extended. However, if the closing price reverses by a
pre-determined "reversal" amount, a new Kagi line is
drawn in the next column in the opposite direction. An
interesting aspect of the Kagi chart is that when closing
prices penetrate the prior column's high or low, the
thickness of the Kagi line changes.
To draw Kagi lines, compare the close to the ending point of the last
Kagi line. If the price continues in the same direction as the prior line,
the line is extended in the same direction, no matter how small the move.
However, if the closing price moves in the opposite direction by the
reversal amount or more (this could take a number of sessions), then a
short horizontal line is drawn to the next column and a vertical line is
continued to the new closing price. If the closing price moves in the
opposite direction of the current column by less than the reversal amount
then no lines are drawn.

In addition, if a thin Kagi line exceeds the prior high point (on the Kagi
chart), the line becomes thick. Likewise, if a thick Kagi line breaks a
prior low point, the line becomes thin.
RENKO CHART
The Renko charting method is thought to have acquired its name
from "renga" which is the Japanese word for bricks. Renko charts
were introduced by Steve Nison (a well-known authority on the
Candlestick charting method).
Renko charts are similar to Three Line Break charts except that in a
Renko chart, a line (or brick as they are sometimes called) is drawn
in the direction of the prior move only if a fixed amount (i.e., the
box size) has been exceeded. The bricks are always equal in size.
For example, in a five unit Renko chart, a 20 point rally is
displayed as four equally sized, five unit high Renko bricks
To draw Renko bricks, today's close is compared with the high and
low of the previous brick (white or black). When the closing price
rises above the top of the previous brick by the box size or more,
one or more equal height, white bricks are drawn in the next column.
If the closing price falls below the bottom of the previous brick by
the box size or more, one or more equal height, black bricks are
drawn in the next column.
If the market moves up more than the amount required to draw one
brick, but less than the amount required to draw two bricks, only one
brick is drawn. For example, in a two unit Renko chart, if the base
price is 100 and the market moves to 103, then one white brick is
drawn from the base price of 100 to 102. The rest of the move--
from 102 to 103--is not shown on the Renko chart. The same rule
applies anytime the price does not fall on a box size divisor.
POINT & FIGURE CHART
Point & figure (P&F) charts differ from "normal" price charts in that they completely
disregard the passage of time and only chart changes in prices. Rather than having
price on the y-axis and time on the x-axis, P&F charts display price changes on both
axes.
P&F charts display an "X" when prices rise by the "box size" and display an "O"
when prices fall by the box size. Note that no Xs or Os are drawn if prices rise or fall
by an amount that is less than the box size.

Each column can contain either Xs or Os, but never both. In order to change
columns (e.g., from an X column to an O column), prices must reverse by the
"reversal amount" multiplied by the box size. For example, if the box size is 3 points
and the reversal amount is 2 boxes, then prices must reverse direction 6 points (3
times 2) in order to change columns. If you are in a column of Xs, the price must fall
6 points in order to change to a column of Os. If you are in a column of Os, the price
must rise 6 points in order to change to a column of Xs. The changing of columns
signifies a change in the trend of prices.
Because prices must reverse direction by the reversal
amount, each column in a P&F chart will have at least
"reversal amount" boxes.
When in a column of Xs or Os, MetaStock will first
check to see if prices have moved in the current
direction (e.g., rose if in a column of Xs or fell if in a
column of Os) before checking for a reversal.
MetaStock uses the high and low prices to decide if
prices have changed enough to display a new box.
LONG STM EQUIVOLUME CHART
LONG STM RENKO CHART
Conclusion:
Charting techniques help the trader visualize promising
patterns. Chart analysis is part of technical analysis, technical
analysis is not the only way to go, a trader should in my view
also do some fundamental analysis and protect his money with
a sound money management technique.
The head and shoulders formation is very common and in this
paper I have tried to give it a sound natural basis.
References:
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Chicago,1990
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Gloucester, 1993
5. M.J. Pring, Analisi tecnica dei mercati finanziari, Mcgraw-Hill,Milano,1989
6. E. Coliva, L. Galati, Analisi tecnica e finanziaria, Utet, Torino,1992
7. A. Fornasini, Analisi tecnica e fondamentale di borsa, Etas Libri, Milano,1991
8. A. Fornasini, A. Bertotti, Analisi tecnica dei mercati finanziari, Etas, Milano,1992
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York,1986
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York,1991
13. S. Nison, Beyond candlesticks, John Wiley & Sons, Inc., New York, 1994
14. R.W. Arms, Jr., Volume cycles in the stock market, Equis International, Inc.,U.S.A., 1994
15. L.G. McMillan, Options as a Strategic Investment, New York Institute of Finance, New
York,1993