The Handbook of Technical Analysis + Test Bank. Lim Mark Andrew

that price exceeds the upper volatility band, which may potentially be an early indication of price exhaustion, especially since it is accompanied by a significant volume spike. The moving average convergence-divergence (MACD) indicator is also seen to be residing at historically overbought levels, which is another potentially bearish indication.

Figure 1.15 Volatility Band, Volume, and Overextension Analysis on the Same Chart.

      Source: MetaTrader 4

      As we can see from just a few forms of analysis presented in the preceding charts, there are many ways to view the action of the markets, depending on the context of the analysis employed. For example, if the analyst is more interested in viewing and understanding the action of price within the context of over-reaction or price exhaustion in the markets, he or she may opt to apply technical studies that track levels or areas of potential over-reaction or price exhaustion. Technical studies that tract such behavior include linear regression bands, Bollinger bands, moving average percentage bands, Keltner and Starc bands, areas of prior support and resistance, and so on. Alternatively, if the analyst is more interested in viewing and understanding the action of price within the context of market momentum, he or she may instead opt to apply breakout analysis of chart patterns, trendlines, moving averages, and so on. As long as the reason for using a particular form of analysis is clear, there should be no confusion as to what the studies are indicating.

       Contradictory, Confirmatory, and Complementary Signals

      There are many instances when two oscillator signals are in clear and direct opposition with each other. This is inevitable, as each oscillator is constructed differently. The mathematics underlying each oscillator varies with the purpose it is designed for, and in most cases, it involves the manipulation of price, volume, and open interest data. A few reasons for conflicting oscillator and indicator signals are:

      • The mathematical construction of each oscillator or indicator is different.

      • Each oscillator or indicator tracks a different time horizon.

      • Two identical oscillators may issue inconsistent readings due to missing data on one of the charting platforms.

      • Two identical oscillators may also issue inconsistent readings due to variations in the accuracy, quality, and type of data available on different charting platforms.

      For example, applying an oscillator that uses price, volume, and open interest as part of its calculation will yield inconsistent readings should one of the data be unavailable on the charting platform. The analysts may not be aware of the missing data and struggle to make sense of the inconsistency. The accuracy of the data is also of paramount importance for effective analysis of price and market action. Dropouts in the data as well as the inclusion or exclusion of non-trading days will cause inconsistent readings between charting platforms. There may also be variations in the oscillator readings should volume be replaced with tick volume, sometime also referred to as transaction volume. Tick volume tracks the number of transactions over a specified time interval, irrespective of the size of the transactions.

It is also important to note that conflicting signals may not always be in fact conflicting. As pointed out, the time horizons over which each signal is applied may be different. In Figure 1.16 we observe that the CCI readings over the range of prices are markedly different. The 20-period CCI indicates a slightly overbought market whereas the 100-period CCI suggests that prices are slightly oversold. There is in fact no real conflict between the two apparently opposing signals. The indicators are merely pointing out that prices are slightly overbought or overextended in the short term, but over the longer term, prices are in fact slightly oversold, that is, relatively cheap. Therefore, instead of viewing the signals as opposing or contradictory, the astute trader immediately realizes that the most advantageous point for initiating a long entry would be when prices are cheap both in the long and short term. This is easily identified on the charts by looking for oversold readings on both the 20- and 100-period CCI within the area of consolidation, as indicated at Point 1. Therefore, the trader may decide to go long once price penetrates the high of the candlestick indicated on the chart. In this example, we see conflicting signals actually complementing each other and affording the trader an advantageous entry at relatively low prices.

Figure 1.16 Conflicting Signals on the Daily Alcoa Inc Chart.

      Courtesy of Stockcharts.com

      The important point to remember is that any form of analysis may be employed, as long as the analyst is intimately familiar with the peculiarities associated with each form of analysis. It is better to be conversant with one form of analysis than to employ a slew of technical approaches without fully grasping the intricacies of each approach. This leads to confusion and ineffective analysis. It must be noted that combining technical studies will frequently result in both confirmatory and contradictory signals as we have seen, with many of the signals being also complementary as well. Only add studies once the first form of analysis is fully mastered. The practitioner must always remember that no form of analysis is always perfectly representative of the market, and it is inevitable that different forms of analysis will many times lead to conflicting signals.

       Subjectivity in Pattern Identification

      As mentioned, interpretation and inference of potential future price action based on historical price behavior is essentially an exercise in subjectivity. Each analyst will interpret and infer future price action according to his or her own experience, knowledge, objectives, beliefs, expectations, predilections, emotional makeup, psychological biases, and interests.

The identification of price patterns may also present some challenge to the novice practitioner. Occasionally, the markets will conveniently trace out various price patterns that may cause some confusion. Refer to Figure 1.17.

Figure 1.17 Conflicting Chart Pattern Signals.

      In this example, we see two chart patterns indicating potentially contradictory signals. The ascending triangle is regarded as a bullish indication, while the complex head and shoulders formation is potentially bearish. Therefore, as price starts to contract, forming a symmetrical triangle, an analyst may be somewhat perplexed at the conflicting signals, being unable to provide or issue a clear forecast as to whether the market is indeed potentially bullish or bearish.

      One way to resolve this apparent conflict is to first identify the size of each pattern. The sentiment associated with larger patterns or formations will take precedence over that of smaller formations. These larger formations are more representative of the longer-term sentiment whereas the smaller formations are more indicative of short-term sentiment. Hence in our example, the bullish sentiment associated with the ascending triangle takes precedence over the bearish sentiment associated with the complex head and shoulders formation. Therefore, until price breaches the complex head and shoulders neckline, the entire formation may be regarded as a potentially bullish pattern. Following this simple rule helps reduce some of the subjectivity involved in reading price and chart formations.

Figure 1.18 depicts an idealized scenario where all the chart formations are potentially bearish.

Figure 1.18 Chart Pattern with Complementary Signals.

      There is no conflict in sentiment between these formations as they are all in perfect agreement. The smaller formations act as additional evidence and add to the overall bearish sentiment. There is also a lesser amount of subjectivity involved when reading the sentiment associated with formations that are in perfect agreement. Nevertheless, it should be noted that although such formations may appear somewhat more straightforward with respect to inferring potential future price direction, any upside