Number 3
This month
in the ChartFilter Newsletter I'd like to focus
on the use of the group of indicators that includes
Bands, Envelopes and Channels. Extensive testing
by Lukac and Brorsen (The Financial Review - Nov
1990) has shown that channel breakouts and moving
average systems are some of the most useful indicators
available.
Please
note that we have used historical data. These examples
are for educational purposes only.
CURRENT
TRENDS - Learning from the TSE 300 Index
The TSE
300 Composite Index has been in a strong uptrend
since June this year. How do we monitor the trend
to watch for any changes in the overall strength
of TSE stocks? Envelopes and bands offer one quick
way of keeping your eye on the bouncing markets.
This analysis shows that the TSE 300 is still in
a healthy uptrend. However there was a sign of potential
weakness during late July - early August. What does
the TSE 300 look like today?
The MA
envelope plots two lines placed at a fixed percentage
(e.g., 3%) above and below a Moving Average (thus
also known as Percentage Envelopes). A strong penetration
through the envelope in either direction can be
a useful indicator. Usually a filter mechanism is
added to ensure that the penetration is truly significant;
the most commonly used filter is a certain number
of closing prices outside the envelope - usually
3 consecutive daily closes.
You can
see how the MA Envelope is not very helpful during
sideways trending markets - shown by the blue trendlines.
Once the market began to trend in early June, however,
the signals offered by the MA envelope system once
again proved very helpful.
In the
TSE chart below we can see that as long as the price
stays above the centre moving average and along
the upper envelope, we can be fairly safe in assuming
that the trend is healthy and set to continue. The
current price is right on top of the upper band;
sign of a continuing healthy uptrend at this time.
Remember,
as with any indicator, the signals are not 100%
reliable (they never are!). This is why you need
to confirm any signals using other indicators.
The next
chart shows the TSE 300 again, this time using the
Price Channel indicator
(focussing on the past 3 months). Also known as
the 4 week rule or the Dochian Channel (after its
original developer Richard Donchian); this indicator
is simple but it works extremely well. Basically
it tells you what the price is doing in relationship
to the highs and lows of the previous 4 weeks. The
upper line (or channel) plots the highs of the previous
4 weeks (20 trading days), and the lower line plots
the lows. A breakout above the upper line shows
that the market is exceeding any highs set over
the previous 4 weeks. Once again, a strong penetration
though the upper channel with at least 3 consecutive
closes above the line can be considered a good buy
signal.
Price Channels
and MA Envelopes should be used in combination with
other indicators, such as RSI or MACD, to provide
confirmation of the strength of a market. An exit
strategy utilizing trendlines and other indicators
can be particularly important. Waiting for the price
to close below the lower band often erodes much
of the potential profits from a good move.
Compare
the two sets of charts to see what these two systems
are telling you. I would also recommend using these
techniques to monitor the health of some of the
other indices as well as sectors.
TIPS
& TECHNIQUES - Using Bands & Channels
The Price
Channel is a simple breakout system. As a trend
following system the Price Channel indicator is
not meant to catch tops or bottoms. Trend traders
may want to extend the period to eight weeks to
wait for significant trend signals. Similarly, some
traders shorten the time period to a more sensitive
1 or 2 weeks for liquidation purposes.
See Price
Channel
Bollinger
Bands are two winding parallel lines above and
below a central moving average (MA) create a band
that contains the majority of price movements within
a channel. This is similar to moving average envelopes.
The difference is that Bollinger Bands are also
sensitive to volatility in the market. The bands
spread further apart during volatile markets and
come closer together during calmer markets.
See Bollinger
Bands
The Keltner
Channel is based on the Average True Range and
is sensitive to volatility. It may be used in place
of standard deviation (Bollinger) bands or percentage
envelopes.
See Keltner
Channel
PROFIT
POTENTIAL - Fairfax Financial
Fairfax
Financial (FFH) on the Canadian TSE has been in
a strong downtrend and sideways trend since December
1999. It is showing signs of a possible bottom.
When we apply trendlines and Bollinger Bands to
this stock we can see that it may be showing signs
of a turn around.
Here's
FFH over the past six months with Bollinger
Bands shown. The red circle shows an enlarged
view of the price action when the price penetrated
through the upper band and made three consecutive
closes above the line. This is usually considered
a buy signal with Bollinger Bands.
Keep an
eye on the Bollinger Bands to see if this stock
stays close to the upper trend line. It is interesting
to note that the activity we saw in late July (upper
band penetration and three consecutive closes) occurred
only once in this six month period.
You might
want to experiment with the use of MA Envelopes
and Price Channels on this same stock to see if
they provided added evidence of a possible turn-around
for FFH.
Putting
ChartFilter into Context
ChartFilter
is meant to complement your overall trading knowledge
and decision-making. This newsletter focuses on
applying technical analysis (TA) methods to various
markets; but this is not to say that you shouldn't
be considering important fundamental criteria, such
as EPS or revenue, as well. Think of ChartFilter
as your TA assistant; not as your overall trading
strategist.
There's
lots more to come! Your comments or suggestions
are always welcome; e-mail us at Newsletter@ChartFilter.com.
