Speed Resistance Lines

SPEED RESISTANCE LINES

Speaking of thirds, let's touch on another technique that com­bines the trendline with percentage retracements—speedlines. This technique, developed by Edson Gould, is actually an adaptation of the idea of dividing the trend into thirds. The main difference from the percentage retracement concept is that the speed resis­tance lines (or speedlines) measure the rate of ascent or descent of a trend (in other words, its speed). To construct a bullish speedline, find the highest point in the current uptrend. (See Figure 4.21a.) From that high point on the chart, a vertical line is drawn toward the bottom of the chart to where the trend began. That vertical line is then divided into thirds. A trendline is then drawn from the beginning of the trend through the two points marked off on the vertical line, representing the one-third and two-thirds points. In a downtrend, just reverse the process. Measure the vertical distance from the low point in the downtrend to the beginning of the trend, and draw two lines from the beginning of the trend through the one-third and two-thirds points on the vertical line. (See Figures 4.21a and b.)

Figure 4.21a Examples of speed resistance lines in an uptrend. The vertical distance from the peak to the beginning of trend is divided into thirds. Two trendlines are then drawn from point 1 through points 2 and 3. The upper line is the 2/3 speedline and the lower, the 1\3. The lines should act as support during market corrections. When they’re broken, they revert to resistance lines on bounces. Sometimes these speedlines intersect price action.

Figure 4.21b Speedlines in a downtrend.

Each time a new high is set in an uptrend or a new low in a downtrend, a new set of lines must be drawn (because there is now a new high or low point). Because the speedlines are drawn from the beginning of the trend to the one-third and two-thirds points, those trendlines may sometimes move through some of the price action. This is one case where trend­lines are not drawn under lows or over highs, but actually through the price action.

If an uptrend is in the process of correcting itself, the downside correction will usually stop at the higher speedline (the 2/3 speedline). If not, prices will drop to the lower speedline (the V3 speedline). If the lower line is also broken, prices will probably continue all the way to the beginning of the prior trend. In a downtrend, the breaking of the lower line indicates a probable rally to the higher line. If that is broken, a rally to the top of the prior trend would be indicated.

As with all trendlines, speedlines reverse roles once they are broken. Therefore, during the correction of an uptrend, if the upper line (2/3 line) is broken and prices fall to the V3 line and rally from there, that upper line becomes a resistance barrier. Only when that upper line is broken would a signal be given that the old highs will probably be challenged. The same principle holds true in downtrends.

GANN AND FIBONACCI FAN LINES

Charting software also allows the drawing of Gann and Fibonacci fan lines. Fibonacci fan lines are drawn in the same fashion as the speedline. Except that Fibonacci lines are drawn at 38% and 62% angles. (We’ll explain where those 38% and 62% numbers come from in Chapter 13, "Elliott Wave Theory.") Gann lines (named after the legendary commodity trader, W.D. Gann) are trendlines drawn from prominent tops or bottoms at specific geometric angles. The most important Gann line is drawn at a 45 degree angle from a peak or trough. Steeper Gann lines can be drawn during an uptrend at 633/4 degree and 75 degree angles. Flatter Gann lines can be drawn at 26V4 and 15 degree lines. It's possible to draw as many as nine different Gann lines.

Gann and Fibonacci lines are used in the same way as speedlines. They are supposed to provide support during down­ward corrections. When one line is broken, prices will usually fall to the next lower line. Gann lines are somewhat controversial. Even if one of them works, you can't be sure in advance which one it will be. Some chartists question the validity of drawing geo­metric trendlines at all.

INTERNAL TRENDLINES

These are variations of the trendline that don't rely on extreme highs or lows. Instead, internal trendlines are drawn through the price action and connect as many internal peaks or troughs as possible. Some chartists develop a good eye for this type of trend­line and find them useful. The problem with internal trendlines is that their drawing is very subjective; whereas the rules for draw­ing of more traditional trendlines along the extreme highs and lows are more exact. (See Figure 4.21c.)

REVERSAL DAYS

Another important building block is the reversal day. This particu­lar chart formation goes by many names—the top reversal day,

Figure 4.21c Internal trendlines are drawn through the price action connecting as many highs and lows as possible. This internal trendline drawn along the early 1996 highs provided support a year later during the spring of 1997.

the bottom reversal day, the buying or selling climax, and the key reversal day. By itself, this formation is not of major importance. But, taken in the context of other technical information, it can sometimes be significant. Let's first define what a reversal day is.

A reversal day takes place either at a top or a bottom. The generally accepted definition of a top reversal day is the setting of a new high in an uptrend, followed by a lower close on the same day. In other words, prices set a new high for a given upmove at some point during the day (usually at or near the opening) then weaken and actually close lower than the previous day's closing. A bottom reversal day would be a new low during the day followed by a higher close.

The wider the range for the day and the heavier the vol­ume, the more significant is the signal for a possible near term trend reversal. Figures 4.22a-b show what both would look like on a bar chart. Note the heavier volume on the reversal day. Also notice that both the high and low on the reversal day exceed the range of the previous day, forming an outside day. While an out­side day is not a requirement for a reversal day, it does carry more significance. (See Figure 4.22c.)

The bottom reversal day is sometimes referred to as a sell­ing climax. This is usually a dramatic turnaround at the bottom of a down move where all the discouraged longs have finally been forced out of the market on heavy volume. The subsequent absence of selling pressure creates a vacuum over the market, which prices quickly rally to fill. The selling climax is one of the more dramatic examples of the reversal day and, while it may not mark the final bottom of a falling market, it usually signals that a significant low has been seen.

Figure 4.22a Example of a top reversal day. The heavier the volume on the reversal day and the wider the range, the more important it becomes.

Figure 4.22b Example of a bottom reversal day. If volume is especially heavy, bottom reversals are often referred to as “selling climaxes.”

Figure 4.22c The chart action of October 28, 1997 was a classic example of an upside reversal day or a “selling climax.” Price opened sharply lower and closed sharply higher. The unusually heavy volume bar for that day added to its importance. Two less dramatic upside reversal days (see arrows) also marked price bottoms.

Weekly and Monthly Reversals

This type of reversal pattern shows up on weekly and monthly bar charts, and with much greater significance. On a weekly chart, each bar represents the entire week's range with the close registered on Friday. An upside weekly reversal, therefore, would occur when the market trades lower during the week, makes a new low for the move, but on Friday closes above the previous Friday's close.

Weekly reversals are much more significant than daily reversals for obvious reasons and are watched closely by chartists as signaling important turning points. By the same token, month­ly reversals are even more important.

PRICE GAPS

Price gaps are simply areas on the bar chart where no trading has taken place. In an uptrend, for example, prices open above the highest price of the previous day, leaving a gap or open space on the chart that is not filled during the day. In a downtrend, the day's highest price is below the previous day's low. Upside gaps are signs of market strength, while downside gaps are usually signs of weakness. Gaps can appear on long term weekly and monthly charts and, when they do, are usually very significant. But they are more commonly seen on daily bar charts.

Several myths exist concerning the interpretation of gaps. One of the maxims often heard is that "gaps are always filled." This is simply not true. Some should be filled and others should­n't. We'll also see that gaps have different forecasting implications depending on which types they are and where they occur.

Three Types of Gaps

There are three general types of gaps—the breakaway, runaway (or measuring), and exhaustion gaps.

The Breakaway Gap. The breakaway gap usually occurs at the completion of an important price pattern, and usually signals the beginning of a significant market move. After a market has com­pleted a major basing pattern, the breaking of resistance often occurs on a breakaway gap. Major breakouts from topping or bas­ing areas are breeding grounds for this type of gap. The breaking of a major trendline, signaling a reversal of trend, might also see a breakaway gap.

Breakaway gaps usually occur on heavy volume. More often than not, breakaway gaps are not filled. Prices may return to the upper end of the gap (in the case of a bullish breakout), and may even close a portion of the gap, but some portion of the gap is often left unfilled. As a rule, the heavier the volume after such a gap appears, the less likely it is to be filled. Upside gaps usually act as sup­port areas on subsequent market corrections. It's important that prices not fall below gaps during an uptrend. In all cases a close below an upward gap is a sign of weakness. (See Figures 4.23a and b.)

Figure 4.23a The three types of gaps. The breakaway gap signaled the completion of the basing pattern. The runaway gap occurred at about the midway point (which is why it is also called the measuring gap). An exhaustion gap to the upside, followed within a week by a breakaway gap to the downside, left an island reversal top. Notice that the breakaway and runaway gaps were not filled on the way up, which is often the case.

The Runaway or Measuring Gap. After the move has been under­way for awhile, somewhere around the middle of the move, prices will leap forward to form a second type of gap (or a series of gaps) called the runaway gap. This type of gap reveals a situation where the market is moving effortlessly on moderate volume. In an uptrend, it's a sign of market strength; in a downtrend, a sign of weakness. Here again, runaway gaps act as support under the mar­ket on subsequent corrections and are often not filled. As in the case of the breakaway, a close below the runaway gap is a negative sign in an uptrend.

Figure 4.23b The first box shows an “exhaustion” gap near the end of the rally. Prices falling below that gap signaled a top. The second box is a “measuring” gap about halfway through the downtrend. The third box is another “exhaustion” gap at the bottom. The move back above that gap signaled higher prices.

This variety of gap is also called a measuring gap because it usually occurs at about the halfway point in a trend. By measur­ing the distance the trend has already traveled, from the original trend signal or breakout, an estimate of the probable extent of the remaining move can be determined by doubling the amount already achieved.

The Exhaustion Gap. The final type of gap appears near the end of a market move. After all objectives have been achieved and the other two types of gaps (breakaway and runaway) have been iden­tified, the analyst should begin to expect the exhaustion gap. Near the end of an uptrend, prices leap forward in a last gasp, so to speak. However, that upward leap quickly fades and prices turn lower within a couple of days or within a week. When prices close under that last gap, it is usually a dead giveaway that the exhaus­tion gap has made its appearance. This is a classic example where falling below a gap in an uptrend has very bearish implications.

The Island Reversal

This takes us to the island reversal pattern. Sometimes after the upward exhaustion gap has formed, prices will trade in a narrow range for a couple of days or a couple of weeks before gapping to the downside. Such a situation leaves the few days of price action looking like an "island" surrounded by space or water. The exhaus­tion gap to the upside followed by a breakaway gap to the down­side completes the island reversal pattern and usually indicates a trend reversal of some magnitude. Of course, the major signifi­cance of the reversal depends on where prices are in the general trend structure. (See Figure 4.23c.)

Figure 4.23c The two gaps on this daily chart from an “island reversal” top. The first box shows an up gap after a rally. The second box shows a down gap three weeks later. That combination of gaps usually signals an important top.

CONCLUSION

This chapter introduced introductory technical tools that I con­sider to be the building blocks of chart analysis—support and resistance, trendlines and channels, percentage retracements, speed resistance lines, reversal days, and gaps. Every technical approach covered in later chapters uses these concepts and tools in one form or another. Armed with a better understanding of these concepts, we're now ready to begin a study of price patterns.