The general rule that two moving averages are better than one is worth remembering, but you should also remember that sometimes 4- and 10- week averages work, sometimes 5- and 40-week, and sometimes, 2- and 7- day. Brian Marber, a respected UK chartist, uses 63- and 253-day averages (three months and one year). Sometimes weighted moving averages help.
In fact, you could probably demonstrate that they always did, as long as you were prepared to juggle the weighting formula – for instance, give double, triple or quintuple weighting to the latest half, quarter or tenth of the prices – for every chart you saw. Chartists use limitless variations on this theme, including the exponential moving average, which uses all previous prices. Then they go on to use an equally diverse list of secondary indicators to confirm the primary ones. All formulae work some of the time but none works all of the time. As the chartists say about trend line definitions, you have to find out what works for you. If that sounds disingenuous, don’t try charting.
Which brings us to vertical scales. You need to understand what a logarithmic scale is to be a chartist. A log scale puts things in proportion.
For instance, if you bought ClevaNuShops’ shares at 140p, held them for two years and sold at 280p (let’s say the rally continued after all), you’ve made 140p. You did well, but so did the person you sold them to. He held them for just six months and sold at 420p. In other words, he made 140p too. Who made the most money? Neither of you – you both made the same amount. But somehow you know you did better than him.
You did: you doubled your money, for a 100 per cent return (140p profit on a 140p investment: 140 divided by 140 = 1, or 100 per cent). He made only a 50 per cent return (140p profit on a 280p investment:
140/280 = 0.5, or 50 per cent). You did twice as well as him, although he got his return in quarter of the time, which probably puts him ahead on points. A log scale gets this over. Figure 2.21 shows all the information on a normal graph.
Now consider the same information presented on a log scale graph, where the prices are bunched closer together as they get higher (Figure 2.22). A log scale gives as much attention to the percentage change as to the absolute figures themselves. Log scales put big price movements – of say 100 per cent or more – into perspective. In Figures 2.21 and 2.22, the ClevaNuShops price rises by 270 per cent from its low point to its high.
Not many shares do this in such a short period. When you’re dealing with one that does, it’s as well to look at it on a log scale. But, over the space of a few years, many share prices move by this order of magnitude, so long- run prices are often presented in log scale form.
In theory, trend lines and trend channels should be curved when they are applied to log scale graphs. They’re straight on normal graphs, but the effect of bunching the higher numbers on a log scale is to curve anything that was previously straight.
Figures 2.23 and 2.24 depict a share that’s going to be a steady performer for years ahead, although it will be best to get in early. If you inspect them closely, you’ll agree that they’re the same share. In Figure 2.23, a clear long-term trend channel is evident which isn’t going to need any revisions for years. But look what’s happened to it in Figure 2.24.
For unexplained reasons, chartists who use log scales draw straight trend lines on them. Of course, they revise them often, too.
your 100%
return his 50%
return 420p
140p 280p
}
0 100 200 300 400 500
JanApr Jul OctJanApr Jul OctJanApr Jul
}
Figure 2.21 Who makes the most money?
Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul
your 100%
return his 50%
return 420p
140p 280p
}
}
100 200 300 400 500
Figure 2.22 Obviously you, as the log chart shows
0 20 40 60 80 100
Figure 2.23 Straight lines …
1 10 100
50
5
Figure 2.24 … curve on log charts
T he head and shoulders and friends
3
Patterns which say . . . . . . ‘It should start to rise’
. . . ‘It should start to fall’
. . . ‘It will carry on in the same direction’
and words of warning
for as primary indicators of what’s going to happen next. Most investors have heard of these, even if they are ignorant about what they look like and mean.
The patterns fall into two categories. Reversalpatterns, in theory, denote a change of trend – lows which denote the start of an uptrend, and highs which say ‘that’s it, folks’. If you spot one of these, you may expect that a new trend, in the opposite direction to what has gone before, will now commence. The patterns for highs are identical to those for lows, except turned on their heads. Thus, the head and shoulders which tops off an upwards run in the share price corresponds to the inverse head and shoulderswhich would form a bottom after a downwards movement in the share price, indicating that now at least part of the fall should be retraced.
Continuationpatterns occur during a pause in a trend and indicate that it will continue in the same direction as before.
In addition to the basic direction-pointing functions of these patterns, most chartists suggest that close examination of them will enable an estimate to be made of how far the new or continued trend will go.
Modern reversal and continuation patterns are all two-dimensional, in the sense that a shape of some sort can be drawn around them. Charles Dow and his followers in the 1920s and 1930s also identified patterns that had forecasting power, although they defined them as single dimensional lines. In The Dow Theory, Robert Rhea defined a line as:
a price movement extending two to three weeks or longer, during which period the price variation . . . moves within a range of approximately 5 per cent. Such a movement indicates either accumulation or distribution . . . Advances above the ‘line’ . . . predict higher prices; . . . conversely . . . declines below the ‘line’
imply . . . lower prices . . . Inferences drawn from one day’s movement . . . are of but little value except when ‘lines’ are being drawn.
Rhea was in fact discussing the simultaneous movements of the two Dow Averages (Industrial and Transportation), but his thinking gave an early lead to the theories discussed in this chapter.