by Richard Evans

Technical analysis today comes to us under various and sundry names and disguises, ranging from the granddaddy of technical analysis, Dows theory, to a plethora of more exotic forms. However, in its simplest form, technical analysis is the study of the market action itself.

I usually think of technical analysis as transactions analysis, a more descriptive and less threatening term than technical analysis to many investors. In any case, technicians believe that price action, plus volume in many cases, accurately represents the demand and supply for stocks, and (this is the critical leap of faith), that correct appraisal of the supply and demand factors as represented by price and volume patterns can allow technicians to make reasonably accurate forecasts of future price activity.

The original tool of technical analysis was tape reading, which allowed investors to read demand and supply by seeing which stocks were moving, how active they were, and whether they were stronger or weaker relative to others. The basic purpose of tape reading was to answer the question: How is a stock acting?

Some investors began to keep charts to facilitate the tracking of important price levels in order to determine the direction of trading. Many original charts were line charts, where just the closing prices were kept over some specified time period. Since then, many variations on the chart theme have developed, and this article takes a look at three popular forms.

Bar charts take the transactions information a bit further, recording the high and low, as well as the close, plus volume, over time. These are the most popular charts today and are available on many computer systems. Ive asked William ONeil, founder of Investors Business Daily, to help interpret the bar charts found in Daily Graphs, a charting service.

Point and figure charts consider just the closing prices of significant price moves. If there are not any important price changes, there are not any chart entries. Ive asked Mike Burke, editor-in-chief of Investors Intelligence, to interpret this method of chart reading.

Candlesticks are a relatively new form of charting, although Steve Nison, a pioneer in popularizing candlesticks, states that candlesticks have been in use in Japan for centuries. In any case, there are probably few readers who have much familiarity with candlesticks at all, a situation we are going to remedy.

Bar Charts

The bar charts published by William ONeil afford a wide array of information in addition to high, low, close and volume. By my count, there are close to 100 additional pieces of information on the charts, which over time William ONeil has found significant to the investor. How To Read A Chart is found in each issue of Daily Graphs, and many features are explained in ONeils very informative and readable book, How to Make Money in Stocks.

Q. Evans What are the most important factors an investor should consider when investing in a stock?

A. (ONeil) Stock selection is two-fold: part technical analysis, part fundamental analysis.

I consider technical analysis important, since charts for an investor are like X?rays to a doctor or seismic data to a geologist. The basic price and volume patterns of a stock chart enable us to determine whether a stock is strong and healthy or weak and behaving badly. Price and volume patterns permit us to determine if a stock is under accumulation or distribution.

The second, and equally important, aspect of stock selection, fundamental analysis, tells us that firms with rapidly advancing earnings are likely to provide the best profit potential for investors. When buying a stock, an investor should look for a major quarterly percentage increase in current earnings per share. Investors should also understand the firms products or services.

Q. How does your method of using charts for stock selection dovetail with stocks reporting superior earnings increases?

A. Stocks showing very strong earnings increases give us one factor for a possible buy. Then, we look for stocks that are in some period of price consolidation of a few months. Important price moves come off sound price patterns and bases.

Q. Can you explain what you mean by base?

A. One of the more sound price formations is the cup with a handle. The cup is a correction for a stock, usually in line with an overall market correction, where it will decline 15% to 33% or sometimes 1 to two times the market averages. The base lasts usually three to six months. The bottom part of a cup tends to be rounded and give the appearance of a U.

The handle is usually a few weeks in duration and has a downward price drift. There should be an extreme drying up in trading volume near the lows in the price pullback of the handle. The handle should also form in the upper half of the overall base structure.

The buy or pivot point will be marked by an upside breakout on a volume increase that is at least 50% above normal. [As an example, the buy point for Chrysler is marked in Figure 1.]

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Q. It does not look like you are buying at the lows.

A. We are looking not to buy at the lows or the cheapest price, but to buy at exactly the right time, the time at which the real move starts. We have a stock that is coming off a base, and now we have the price breakout on big volume.

Q. Sounds like investors have to stay on their toes to buy right.

A. Right. Not only do investors have to be ready to buy when the stock has crossed the buy point, but on the other side, investors have to watch carefully so that they do not buy after the issue has moved up by more than 5% to 10%. Chasing stocks too much is risky.

Q. Ive had some AAII members ask me how to use the relative strength numbers on the charts.

A. Most analysts tend to look at relative strength [a measure of price trend relative to an index] on an absolute basis, that high relative strength is considered positive. However, what is important is to look for improving relative strength as the stock is emerging from a base pattern. In many cases the relative strength line may precede the stocks price into new high ground.

Q. A summary of your approach, then, is to look for stocks with rapid earnings increases, that have consolidated in a sound and proper base, and then are moving higher.

A. Right. Much of my stock selection guidelines arose out of my market study, The Record Book of Greatest Stock Market Winners, where I look at 500 winning stocks. Successful patterns do repeat.

Point and Figure Charting

While bar charts plot transactions according to time, that is, by the minute, hourly, daily, weekly, monthly, etc. point and figure charts just plot important price movements. Investors Intelligence uses this system, and the editor, Mike Burke, explained their use.

Q. Evans What is the basis of point and figure charting?

A. Burke Point and figure charting is strictly based on price changes and is independent of time. The focus of point and figure is in the reversal patterns. While those obviously will appear at some point in time, were interested in highlighting the reversal.

Q. A picture is worth a thousand words. Construct a chart for us. [See Figure 2]

A. Each square presents a unit of price. For stocks between $20 and $100, each box represents $1. Between $5 and $20, each box represents $0.50; under $5 each box represents $0.25; over $100, each box represents $2.

When prices are rising, we use a column of Xs; when prices are falling, we use a column of Os. However, we only make entries when the price move is significant.

Q. Define significance.

A. I use the three-point charts, which means that a stock has to move $3 (three boxes) or more in order to make an entry. If the stock is unchanged for five weeks, then there are no entries on the chart.

Q. Why three-point?

A. Experience. One-point tends to be too sensitive, but I do use five-point charts to discern more important long-term reversals.

Q. That is the key word you mentioned at the beginningreversals.

A. Yes. We are striving to identify important reversal points. A buy signal is when an up (X) column goes above a previous up (X) column. A sell signal is when a down (O) column goes below a previous down (O) column.

Q. While point and figure charts are different than bar charts, the theory is the same.

A. Correct. Accumulation is represented by a breakout in the X columns; distribution by a breakdown in the O columns. For example, Chock Full ONuts has recently given us a buy, in December, as the current up (X) column rose above the previous up (X) column.

Q. I note numbers, and sometimes the letters A, B, or C, intermixed with the Xs and Os.

A. To account for the time when the move is being made, we use the numbers 1 to 12 to represent months of the year. On computer systems, A, B, and C stand for October, November, and December. Point and figure is not a function of time, but we keep important moves dated for reference.

Q. I note that back in September of 1991 there was a column of Xs moving above a previous column of Xs. Why did the chart not turn bullish at that time?

A. That formation is what I would call a simple buy signal. In any given week we see 20 or 30 buy signals, but that is only the first step.

There are other considerations. At the time Chock Full ONuts was negative on its relative strength. A simple buy according to point and figure has to be confirmed by relative strength.

In order to further understand any one stock we have to take into account how the stock is moving relative to the market. If a stock is dropping in line with the market, it is a much different situation than a stock dropping more or less than the market. And vice versa.

Generally we look to be invested in stocks with improving relative strength.

Candlesticks

Steve Nison is credited with pioneering the use of candlestick analysis. He is director of research at the Nikkhah Group at Refco Inc. a New York-based brokerage firm.

Q. (Evans) What are candlesticks?

A. Nison Candle charts are Japans most popular form of technical analysis. The Japanese have used technical analysis since the late 1600s to trade rice futures on what was probably the worlds oldest futures exchange, in Osaka. The candlestick technique had been developed by generations of use in Japan, but until recently, has been virtually unknown to many in the American financial community.

Q. The name is catchy.

A. The name candlestick obviously arose since the candle charts resemble candles and wicks. However, do not let the name overshadow the fact that candlesticks are a very powerful and unique tool of technical analysis, either as a stand-alone tool, or in conjunction with other technical analysis.

Q. How are candlesticks constructed?

A. Candle charts use the same price data that is needed to draw a bar chart: the high, low, and close. While some bar charts include the open, many published sources do not. Candlesticks, however, make important use of the open, as well as high, low, and close.

But what is important is that candlestick charts have their own signals not available with bar charts and will often allow investors to get a jump on those who just use traditional western charting techniques.

Q. Put together a candlestick.

A. Figure 4 displays some basic candlestick lines. The broad part of the candlestick line is called the real body. The real body represents the range between the sessions open and close. If, as in the first example, the close of the session is lower than the open, then the real body is black. If the real body is white, the close of the session is higher than the open, as in the second example.

The thin lines above and below the real body are called the shadows. The peak of the upper shadow is the high of the session and the bottom of the lower shadow is the low of the session.

Q. Is there any particular time frame in constructing the candles?

A. Candle lines can be drawn for all time frames, from intraday to daily to weekly to monthly. Candles are useful in any market where technical analysis is applicable, ranging from individual stock analysis to hedging currencies.

Q. How do you interpret the candle formations?

A. There are combinations of the basic candle lines that can offer clues to the markets health. For example, if a black candle envelopes a while candle, it is called a bearish engulfing pattern. Often this a sign of a top.

Q. You have an example for a stock in IBM.

A. In IBM [Figure 5] we see such a bearish engulfing pattern. The bearish engulfing pattern is illustrative of how the candle can provide unique insights into the market. Specifically, before the engulfing pattern, we can see pictorially how the bulls are in charge during the preceding uptrend. With the first white candle of the bullish engulfing pattern, the bulls are still in charge. But when a large black candle engulfs the white candle, it is a clue that the bears have wrested control from the bulls.

Besides this pattern, another clue that IBM was in trouble was the window shown on the chart. A window means there is no price action between the last sessions low and this sessions high. To Japanese investors, a window is an important topping action. Windows often also become resistance areas on price rebounds.

Q. So you believe that the individual investor could well benefit to incorporate candlesticks into their programs?

A. Bar charts can often take weeks to reveal a market turn. Most candle patterns are comprised of only two to three sessions. Thus, candle patterns will often give earlier warnings of a market turn than do bar chars. In addition, candlesticks work well in conjunction with other forms of technical analysis, such as moving averages, trend lines, etc. and can provide some very interesting insights with point and figure charts.

Q. Since candlesticks are relatively new, most investors are probably unaware of where to find them.

A. Almost all technical analysis software packages, such as Metastock by Equis, AIQ, CompuTrac, etc. and real time data vendors such as Reuters, Bloomberg, etc. supply charts to their subscribers.