Technical Analyst

mar/apr 2005
The publication for trading and investment professionals
www.technicalanalyst.co.uk
THE MORNING STAR

A powerful candlestick pattern
Outlook for GBP/USD
Japanese charting
Support and resistance
Will defenses
hold?
The essentials of
Ichimoku
Quantifying their
strength
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WELCOME
With EUR/USD approaching an all-time high, economists continue to highlight the
unsustainably large trade deficit as justification for further USD falls. Yet technicians, whilst always happy to follow the trend, are on the look out for signs of a
reversal. In this context, two leading analysts give their views on GBP/USD and
EUR/USD. We also present some useful tools, such as the Morning Star candlestick pattern, that can be used across all markets to spot when prices are likely to
correct or begin a trend reversal.
The Technical Analyst is pleased to announce a seminar to be held in May entitled
"Technical Analysis in the FX Markets". Full details can be found inside this issue.
We hope you enjoy the magazine.
Matthew Clements, Editor
CONTENTS 1 > FEATURES

GBP/USD
Will defences hold?
MAR/APR
>10
Jerry Ficchi, senior technical analyst at

Brown Brothers Harriman, marks out the
levels where cable is likely to find support.
The Morning Star

>12
How three consecutive candlesticks can

signal the bottom of a trend.
An introduction to
Ichimoku
>22
An overview of a much talked about

charting technique from Japan
2005 Clements Biss Economic Publications Limited. All rights reserved. Neither this publication nor any part
of it may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic,
mechanical, photocopying, recording or otherwise, without the prior permission of Clements Biss Economic
Publications Limited. While the publisher believes that all information contained in this publication was correct
at the time of going to press, they cannot accept liability for any errors or omissions that may appear or loss
suffered directly or indirectly by any reader as a result of any advertisement, editorial, photographs or other
material published in The Technical Analyst. No statement in this publication is to be considered as a
recommendation or solicitation to buy or sell securities or to provide investment, tax or legal advice. Readers
should be aware that this publication is not intended to replace the need to obtain professional advice in
relation to any topic discussed.
March/April 2005
>>
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"It always amazes me how some people

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been missing"
36
38
CONTENTS 2 > REGULARS

Editor: Matthew Clements
Managing Editor: Jim Biss
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INDUSTRY NEWS
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MARKET VIEWS
EUR/USD: Preparing to descend
GBP/USD: Will defences hold?
07
10
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The Morning Star
Options open interest - A two way indicator
Sell in May - The month to exit stocks?
An introduction to Ichimoku
Market timing using the NYSE Bullish %
Measuring the strength of support and resistance
Swing trading with flow charts
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March/April 2005
Industry News
Smith Barney lay-off US

technical analysis team
Smith Barney, the brokerage arm of
Citigroup Inc., has laid off its entire
New York based technical analysis
team as part of Citygroups ongoing
round of cost cutting. Technical
analysis at the bank was headed by
Louise Yamada who oversaw a nine-
strong team of analysts and support

staff. All of Smith Barney's technical
research will be handled instead by
Dorsey Wright, a US research house
which also provides technical analysis to firms such as Wachovia and
Dain Rauscher.
REUTERS LAUNCH FIXED INCOME

DESKTOP TRADING
Reuters has launched a new electronic trading service which allows banks
and financial institutions to trade
fixed income securities over their
Reuters desktop. Reuters Trading for
Fixed Income (RTFI) went live on
February 21st with tradable prices
from Deutsche, DrKW, JPMorgan,

Rabobank, RBC and UBS. RTIF
allows users such as asset managers
and hedge funds to trade more than
12,500 cash fixed income securities,
including government and corporate
bonds, across 21 currencies.
ICHIMOKUS CLOUDS
The Japanese charting technique Ichimoku Kinko Hyo - is being
misused, ultimately leading to trading losses. This is the conclusion of
Rick Bensignor, chief technical
strategist at Morgan Stanley in
New York.
Bensignor's recent comments
were made with reference to an
Ichimoku presentation he made
last November at the annual IFTA
conference, after which many
traders went away and started using
the technique. "I certainly didn't
describe the whole model, and I
made that clear," said Bensignor.
"Unfortunately, as is the case when
people think they have a grasp on
something, but truly don't, losses
occur."
Certainly, there is some confusing
debate over the technique, even
with regard to which markets
Ichimoku should be applied to.
Shaun Downey, technical analyst at
CQG, and Steven Smith, Telerate
product manager, both say
Ichimoku works best for Japanese
markets such as JGB's, Nikkei and
the yen. Other analysts, such as Gil
Li of Hong Kong based firm
ProSticks, say Ichimoku is simply
another charting method and can
be applied to all markets.
A large part of the uncertainty
stems from the lack of advanced
reference material on the subject,
at least in the West. Bensignor
plans to fill this gap with a book on
Ichimoku due out later in the year.
FX Seminar in May
The Technical Analyst magazine will
be hosting a one day event entitled
Technical Analysis in the FX
Markets, where anyone who uses
TA in the currency markets - traders,
4
hedge funds and fund managers

has the opportunity to meet and listen to leading analysts. The event
will be held on the 12th of May in
London. Key speakers from UBS,
March/April 2005
Citigroup and Rathbones, among

others, will be discussing the latest
issues in charting the FX markets.
Further details can be found on
pages 34 and 35.
Industry News
ON THE MOVE...
Robin Griffiths has joined Rathbones
Investment Management in London
as head of asset allocation. He was
previously head of technical analysis
within the investment banking arm
of HSBC. Griffiths is responsible
for writing regular strategy and
investment reports for Rathbones
clients.
Trevor Neil has quit his post as head

of technical analysis at Bloomberg to
join South African hedge fund,
Isivuno. He is replaced by Guido
Riolo, formerly an assistant to Neil,
who takes on the role of Technical
Analysis Applications Specialist
based in London.
NEW CME PRODUCTS FOR HEDGE FUNDS US Treasury

The Chicago Mercantile Exchange
has released two new data products;
BBO and MD. The BBO (Best
Bid/Offer) includes: best bid, best
bid volume, best offer, best offer
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five lowest offers. The products can
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from all CME Globex traded products and can be processed daily,
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Allan Schoenberg, director of technology communications at the CME,
"the new products are designed to
meet the needs of customers such as
hedge funds who are building or
adding to their automated and nonautomated trading models".
issuance falls by
20 percent
US government bonds issued in
2004 fell to $5.48 trillion from $6.81
trillion in 2003 according to the US
Bond Market Association (BMA).
The BMA says that stronger US
economic growth and higher shortterm interest rates contributed to
the decline in total issuance.
EXCHANGE NEWS:
Exchanges report record volume in February
The Chicago Board of Trade (CBOT) has reported its most successful
trading day ever on February 29th with 5,852,889 contracts, beating the
previous record set in November last year. Exchange-wide volume
reached a new monthly high in February with total volume at 61,399,407
contracts, up 40.1% from February 2004. The CME also reported record
average daily trading volumes for February of 3.8 million contracts, up
50% from the same month last year.
The London Stock Exchange has announced February as the busiest
trading month on record for the exchange, with an average 308,932
trades per day across all products. This is the first time that average daily
trading volume has exceeded 300,000 and is a 16% rise on February
2004. The LSE says volume continues to be driven by SETS, the
exchange's equity trading service.
Eurex has reported turnover of around 100 million contracts in February, a 24% increase on the same month last
year. Trading in the Euro-Bund future reached a record high of 27.2 million contracts, up 57% on February 2004.
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Market Views
EUR/USD
PREPARING TO DESCEND
by John Noyce
Monthly charts indicate European currencies are attempting to build

a top against the USD.
ver the last three years one of the most persistent

trends in the foreign exchange markets has been
the strengthening of the European currencies
against the USD. The trend has been well discussed and dissected by the press, particularly as EURUSD hit its all-timehighs in December 2004 at 1.3670. At that time, the press
was flooded with articles discussing the plight of the USD
and how much further it had to fall. The frenzy that
occurred as EURUSD hit the highs in December 2004 was,
however, followed by a very sharp and significant correction
lower. This correction enabled a number of patterns to
form - with the most notable developments being on the
monthly charts - indicating this may have been the blow-off
top in EURUSD. These indicators build a strong case that
rather than extending downside targets on the USD, this is
the time to do the exact opposite and to look for opportunities to benefit from a strengthening of the USD against
the European currencies.
Support at 1.25 (Figure 1)
To set the scene, a well-defined uptrend has been in place
since EURUSD based at 0.8563 in late January 2002. The
current trend-defining supports converge on 1.2500: specifically the 55 week moving average at 1.2531, the uptrend
from the October 2002 lows at 1.2627 and the highs of the
July 2004 consolidation at 1.2462. There have been numer-
Figure 1. Weekly EURUSD chart showing long-term supports.

Source: Aspen Graphics. Data: Reuters
March/April 2005
Figure 2. Monthly EURUSD chart showing bearish engulfing month

and negative divergence. Source: Aspen Graphics. Data: Reuters
ous developments on the monthly and weekly charts which

give a strong signal that these supports should be tested
over the coming weeks and months, but which also argue
that this time around (in contrast to the corrections down
from the May 2003 and February 2004 highs) these supports may break to deliver a much larger and more significant correction of the long-term trend.
Monthly technicals (Figure 2)
The purest technical developments have come through on
the monthly charts. First, from the highs of the EURUSD
bull-market, the price action during January 2005 formed a
bearish engulfing candle pattern (the January 2005 open
gapped above the December 2004 close, then closed below
the December 2004 open). This is the first bearish monthly
pattern (from an extreme) in the rally up from the 0.8228
low in October 2000. To accompany this, negative monthly
stochastic divergence has formed against the May 2003,
February 2004 and December 2004 highs (higher highs in
the spot price not being confirmed by higher highs on the
momentum indicators). This momentum divergence indicates the decreasing willingness of market participants to
enter - and crucially - maintain long EURUSD positions as
the currency pair moves towards the top of its multidecade range. The last time this type of divergence was
Market Views
Figure 3. Weekly EURUSD chart with percentage weekly change

(close to close basis). Source: Reuters Graphics
Figure 4. Weekly EURUSD chart overlaid with bar chart showing

extreme numbers of consecutive positive weekly closes. Data Source:
Reuters Graphics
seen on EURUSD was at the lows in 2000, where triple

positive divergence was observable. It has effectively taken
around twenty months for this development to take shape an event that is unlikely to be seen more than once or twice
in a decade.
Sentiment (Figure 5)
In Figure 2 we referred to the negative monthly stochastic
divergence recently forming against the May 2003, February
2004 and December 2004 highs. This shows that on a pure
price action basis, the three major highs on EURUSD have
been set with decreasing momentum and confidence. It is
noteworthy that a similar phenomenon shows through if
you look at market sentiment surveys. Market Vane produces what they term "Bullish Consensus Indices" on a
number of asset markets. In currencies, the most significant
is the bullish consensus on the USD Index, which is an
index of the USD's value. The Sentiment Index runs from
0-100, 0 effectively being bearish and 100 being bullish on
the asset in question. (For the sake of interpretation, the
USD Index effectively trades as the inverse of EURUSD
due to the high weighting of the euro in the index).
As with the monthly stochastic divergence, which shows
decreasing momentum and confidence in buying EURUSD
each time major new highs are set, the sentiment index
Percentage weekly declines (Figure 3)

The two pure technical developments in Figures 2 and 3
offer compelling enough evidence for a test of the support
centred on 1.2500. So what other evidence is there to think
this may be a more significant turning point? Firstly, the
opening week of this year saw EURUSD decline by 3.62% a statistically rare and significant piece of price action.
There is a strong precedent from the two prior major turning points in 1992 and 1995 that following significant highs,
EURUSD posts a large percentage weekly decline: in
September 1992 EURUSD set a major high of 1.4577
(according to Reuters synthetic EUR data) and then posted
its largest ever weekly decline of 6.68% in the following
week. Again, following the high in April 1995 at 1.3525,
after a period of consolidation, EURUSD posted another
major decline of 3.75% in the second week of May. The
only other times moves of this magnitude have been seen
were during the basing process in 2000/2001.
Consecutive weeks up (Figure 4)
Along similar lines to Figure 3, another piece of evidence
relates to the number of consecutive positive weekly closes
on EURUSD. Into the highs in October 1998, nine consecutive positive weekly closes were posted. Similarly into the
January 2004 high at 1.2898, nine consecutive positive
weekly closes were also seen. And into the highs in the last
week of November 2004, a new record was set - eleven
consecutive positive weekly closes. Sequences of positive
weekly closes such as these have only been seen at major
turning points on EURUSD.
Figure 5. Weekly EURUSD chart overlaid with Market Vane USD

Sentiment Index. Data Source: Reuters for EURUSD, www.marketvane.net for USD Sentiment Index
March/April 2005
Market Views
John Noyce
THE THREE MAJOR HIGHS ON EURUSD HAVE BEEN SET

WITH DECREASING MOMENTUM AND CONFIDENCE.
shows a similar pattern. Each of the major lows on the
USD Index (June 2003, February 2004 and December 2004)
has been posted with decreasing negative USD sentiment.
Put another way, as the USD moves closer to the all-timelows of September 1992, a decreasing proportion of market
commentators and forecasters are willing to predict a significant further decline in the USD against the European currencies. Does history shine any light on this relationship?
Yes, it does. As the USD Index made its series of highs in
October 2000, July 2001 and January 2002, the sentiment
index (especially against the October 2000 and January 2002
highs) made significantly lower highs, showing decreasing
positive sentiment on the USD. We all know what happened
from there; the USD Index declined from a high of 120.51
in January 2002 to a low of 80.39 in December 2004 - a fall
of 33.3%.
Conclusion
There is a large body of evidence indicating that EURUSD
March/April 2005
is likely to extend its recent correction over coming weeks

and months towards the long-term supports centred on
1.2500. Added to this, there are a large number of developments, both from a pure price and a sentiment perspective,
which indicate these supports around 1.2500 may not hold,
allowing for a much larger correction to unfold this time
around.
John Noyce is technical analyst for Citigroup Foreign

Exchange
Copyright 2005 Citibank N.A. All rights reserved. Any unauthorised use,
duplication or disclosure is prohibited by law and may result in prosecution.
CitiFX, Citigroup and the Umbrella Device are trademarks and service marks
of Citicorp or its affiliates and are used and registered throughout the world.
Citibank is authorised and regulated by the Financial Services Authority.
Market Views
GBP/USD
WILL DEFENCES HOLD?
by Jerry Ficchi
orrective weakness should be the phrase associated

with cable as 2005 progresses. Sterling has had a
stratospheric run since posting its 2001 low of
1.3675, but indications are that highs have been set for the
time being and that the rate is on its way to targeting 1.7305
as a minimum before regaining its footing.
Though a bit longer-term than necessary for this forecast,
but providing an excellent indication of how overbought
cable currently is,
quarterly slow stochastics are spending
their fifth consecutive
period above 80%.
It's unlikely the study
will linger much
longer in this condition, especially with a
bearish divergence
appearing on monthly
charts. Besides this
divergence (higher
spot highs corresponding with lower stochastic highs) - a very
reliable warning in
itself that the market
has overextended and
Figure 1.
needs to correct - a
shooting star appeared for December's candlestick. A
shooting star candlestick takes the form of a long upper
shadow, little or no lower shadow, and a tight real body near
the lows of the period. Though called a reversal candle, a
shooting star simply implies the end of the current bull
trend and a strong tendency for corrective weakness.
The first support target for this anticipated correction
comes in at 1.8460, represented by the 200-day moving
average. Besides only brief flirtations beneath this moving
average, cable has been guided higher by it since being propelled in mid-2002. This well watched average may prove
stubborn on initial attempts, but its penetration should trigger sell stops and accelerate sterling's correction.
Additionally, since 2002, the 20-month moving average
has supported GBP/USD brilliantly, providing an excep-
10
tional bounce in September 2003. Supportive bids are likely

to remain near it at its current level of 1.7945 with even
larger sell stops lingering below. Its breach, especially with a
monthly close posted beneath it, will finally provide a signal
to those late to the sell-off that a correction is well underway.
Corrections normally have enough follow through to
retrace 38.2%, 50.0% or even 61.8% of a trend before basing. Interestingly, taking the move from
2001's low to 2004's
high, an upward sloping trendline will
intersect with the
prior trend's 38.2%
retracement at 1.7305
in May. The doubled
importance of this
support level should
attract cable like a
magnet, especially
given it roughly coincides with the highs
from 1998. It's quite
possible that bids surrounding this congested 1.7305 area may be
enough to end the
correction and drive the rate higher again. If penetrated,
however, there are more benchmark levels below which
would be targeted and, in turn, take their chances in halting
the corrective slide.
The 50.0% retracements of the underlying trend rests at
1.6615 while the 62.8% level comes in at 1.5920. Between
these two Fibonacci retracements sit both the 100- and 200month moving averages. Besides adding their own support,
the narrowing distance between the two suggests a pending
cross that graphically depicts the market's intention of buying sterling on dips over the longer-term.
Jerry Ficchi is senior technical strategist at Brown
Brothers Harriman in New York
March/April 2005
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Techniques
THE MORNING STAR

by Steve Bigalow
12
March/April 2005
Techniques
apanese traders say "let

the market tell you what
the market is going to
do." Yet it is difficult at times
to sort out what market
direction will be when listening to the many scenarios
presented by the financial
press. Using candlestick
charts will allow investors to
filter out the noise.
Candlestick analysis allows investors

to anticipate trend reversals with a relatively high degree of accuracy. One
misconception about candlesticks signals is that there are too many of them
to learn. Of the 50 or so candlestick
signals, there are only about 12 signals
that will occur the vast majority of the
time: The doji, the bullish and bearish
engulfing signal, the hanging Man, the
shooting star, the hammer, the inverted
hammer, the bullish and bearish
Harami, the dark cloud, the piercing
pattern, and the kicker signal. Knowing
just these signals alone will dramatically
improve your analysis of trend reversals and allows the trader to be positioned in the right direction when a
move occurs.
The Morning Star signal is one of the
most clear, symmetrical candlestick
reversal patterns. It foretells that
brighter things are about to occur and
that prices are going to go higher.
Three-day bottom
The signal is formed after an obvious
downtrend and reveals simple common
sense features that identify a change in
investor sentiment. The three-day signal consists of a long black body on the
first day, usually one produced from the
fear induced at the bottom of a long
decline. The following day - the star day
- gaps down but the magnitude of the
trading range remains small for the day.
This results from a day of indecision.
The third day is a white candle day and
represents the fact that the bulls have
now stepped in and seized control. The
March/April 2005
optimal Morning Star signal would

have a gap before and after the star day.
The star day can be made up of any
number of candle formations that indicate a day of indecision - with a black
or a white body - but a doji or a spinning top is usually the predominant formation. The important factor is the
confirmation of the bulls taking control the next day. That candle should
consist of a closing more than half-way
up the black candle of two days prior
(Figure 1).
It's worth noting that the opposite
but equivalent signal to the Morning
Star - the Evening Star - starts with a
large white candle body and foretells of
prices heading down.
Signal strength
Identifying the Morning Star signal is
relatively easy. There are some very
simple parameters that can enhance the
Morning Star signal's probabilities of
indicating a reversal:
1. The longer the black candle and the
white candle, the more forceful the
reversal. This demonstrates a more dramatic change in investor sentiment
2. The more indecision that the star day
illustrates, the greater the probability
that a reversal will occur.
3. A gap between the first day and the
second day adds to the probability that
a reversal is occurring. A gap before
and after the star day is even more
desirable.
4. The higher the close of the third day,
coming up past the middle point of the
black candle of the first day, reveals
more potential in the strength of the
reversal.
Figure 1.
13
Techniques
THE PROBABILITY OF A MORNING STAR SIGNAL

REVERSING A TREND BECOMES EXTREMELY HIGH
WHEN FOUND IN OVERSOLD CONDITIONS.
The probability of a Morning Star signal reversing a trend becomes extremely high when found in oversold conditions. Using a simple indicator such as
stochastics, the 20 area or below represents an oversold condition. However,
the most important element of the signal is the magnitude of the white candle's close on the third day.
Candlestick analysis can be used in all
markets and across all time frames. As
seen in the daily Dow chart (Figure 2),
the Morning Star signal revealed when
the Dow established a bottom. In July
and August 2004, the Dow reversed
after Morning Star signals. Note point
A when the stochastics were on the
oversold condition, a three-day morning star signal appeared. Two Morning
Star signals then appeared a week later
(point B) to start the next rally. Figure 3
is a chart of the stock AVI Biopharma.
A Morning Star signal appeared in early
August just as the markets were bottoming and successfully anticipated the
beginning of a short-term rally
Candlestick signals occur in the markets everyday and charting software
makes finding these very easy. The
identification of the simple Morning
Star signal, occurring in oversold conditions, allows you to anticipate a trend
reversal and offers a good chance of a
making a successful trade.
Stephen Bigalow is director and editor of www.candlestickforum.com,

a website providing information
about Japanese candlestick investing.
14
Figure 2.
Figure 3.
March/April 20052004
Techniques
OPTIONS OPEN INTEREST

A two way indicator
uccessful trading is
about finding a unique
edge that gives you an
advantage on others. One
approach we use is to maintain an awareness of open
interest changes on call and
put options - a commonly
neglected area of analysis.
This information gives us
two crucial insights. First, it
helps us gauge market sentiment. And second, it can be
used to pinpoint significant
support and resistance levels
on the underlying stock or
index.
What is open interest?
Open interest is the number of outstanding contracts on a particular
option class or series. When a buyer is
entering a new long position and the
by Jon Lewis & Todd Salamone
seller is simultaneously opening a new

short position one contract is created.
It is important to realize the distinction between open interest and volume.
Volume simply refers to the number of
contracts that trade on a particular
option during the day. It provides an
indication of the level of activity on an
option, yet unlike open interest, volume
does not provide a clear indication of
option demand. For example, an
option could have volume of 1,000
contracts in a day, yet open interest
could increase, remain unchanged, or
decrease. It is the daily assessment of
the sum total of activity - in the form
of open interest - that is of more use as
an indicator of sentiment.
A sentiment indicator
Some options analysts only look at the
put and call volume on a stock or index
each day. We have found that by study-
March/April 2005
ing open interest and open interest

changes, one can easily surmise
whether or not put and call volume is
resulting in a liquidation of current
open contracts or a further accumulation of contracts. Open interest is
smoother data than volume because it
is calculated based on changes from the
prior day's open interest, while volume
starts anew each day.
A comparison of total call open interest to total put open interest can give an
analyst a snapshot of the sentiment on
an underlying stock, index, or futures
instrument. Such data can be collected
on a daily basis and used to pinpoint
extremes in optimism and pessimism
for the particular underlying by calculating a put/call open interest ratio.
The higher the ratio, i.e., the higher the
relative level of puts to calls, the higher
the pessimism. Conversely, the lower
the ratio, the greater the optimism.
15
Techniques
By analyzing open interest changes, one

can come away with a more accurate
understanding of the sentiment among
options speculators.
Some might argue that not all open
interest is generated by buyers and that
it would be too simplistic to claim that
put open interest, for instance, is purely the result of pessimistic sentiment.
While it is true that option selling can
represent a material portion of open
interest, the majority of option activity
and changes to open interest come
from the buy side.
Furthermore, selling options does not
necessarily represent sentiment exactly
opposite from that of buying. For
example, straight call buying is clearly
based on the expectation that the
underlying stock or index will rise. But
call selling is not in itself a vote for the
downside. Why? Most call selling takes
the form of covered call writing. One
could argue that selling covered calls is
not outright bearish, but more of a
neutral-to-bullish strategy in which the
seller is looking to generate additional
income while maintaining a position in
the underlying stock. If an investor

were truly bearish, he would more than
likely sell his shares, short the stock or
buy a put. A similar point could be
argued on the put side. Selling out-ofthe-money puts can be a successful
strategy if the stock stays flat or even
drops somewhat. As long as the put
stays out of the money, the put seller
will enjoy a successful trade. Thus, we
maintain that open interest taken in its
entirety can be reflective of optimism
and pessimism.
We take the analysis of open interest
one step further by using options with
three or less months to expiration.
These short-term options tend to
attract a more speculative crowd and
are thus more reflective of the current
sentiment. The resultant ratio is
referred to as the Schaeffer's put/call open
interest ratio (SOIR).
One thing to realize about individual
equity open interest is that while the
theme of pessimism being bullish and
optimism being bearish generally holds
true, each stock's put/call ratio is
unique and has its own timing implica-
Open Interest
0
3,000
6,000
9,000
12,000
15,000
100
95
Price and Strike Level
90
85
80
75
70
Call Open Interest

Put Open Interest
XOM Price
65
60
55
1/2/00
1/24/00
2/15/00
3/8/00
3/30/00
Date
Figure 1.
16
March/April 2005
4/21/00
tions. There are several ways we use

SOIR to analyze sentiment - absolute
levels, relative levels, and in conjunction
with technical factors. On an absolute
basis, most stocks will have greater call
open interest than put open interest.
Thus, when puts outnumber calls
(SOIR greater than one), this tends to
suggest that pessimism is running high
on a stock, although this is not necessarily the case for all equities. One way
to accurately judge the relative optimism and pessimism on a stock at a
particular time is to compare the current SOIR to its own previous readings.
We track the put/call ratios for over
2,000 stocks and 30 sectors over the
previous year and compare each daily
SOIR to the previous year's worth of
readings. By doing this, we are able to
calculate a percentile ranking for the
current SOIR to capture the current
relative sentiment environment.
The most important consideration
when interpreting SOIR is to view the
data in light of the current technical
backdrop for a stock or index. For
example, one would expect that a struggling stock would have an SOIR that is
trending higher. Likewise, optimism in
the form of a low SOIR would logically accompany a stock that is breaking
out to new highs. It is when option
players and the underlying trend are in
contrast that we can begin to get
stronger reads on a stock's future direction. For example, a stock in a strong
uptrend that has an SOIR that is also
trending higher (i.e., rising pessimistic
sentiment) is enjoying a very bullish
environment as fear indicates that there
is plenty of buying power in reserve to
keep the trend intact. In contrast, a
declining SOIR for an underperforming stock entrenched in a decline paints
a bearish picture as there is little buying
power available to reverse the trend.
Thus, sentiment should not be viewed
as a static, one-dimensional indicator.
Sentiment trends within the context of
the technical environment will give the
investor a clearer picture of a stock's
potential.
Techniques
WHEN OPTION PLAYERS AND

THE UNDERLYING TREND ARE IN
CONTRAST... WE CAN BEGIN TO
GET STRONGER READS ON A
STOCKS FUTURE DIRECTION.
A technical indicator
Another way to use open interest is to
analyze a stock's open interest configuration (the number of puts and calls at
various strike levels) to pinpoint potential support and resistance levels. For
example, Figure 1 shows the open
interest for the April series on Exxon
Mobil (XOM) from a few years back.
Note that the 85 strike contains the
most call open interest while the site of
peak put open interest is the 70 strike.
Also note that the stock was well contained between the 70 and 85 strikes
through to the expiration of these April
options.
How do these levels act as potential
support and resistance points? First,
round-number levels tend to serve as
support or resistance as investors view
pullbacks to levels such as 70 for XOM
as good entry points for long positions
or potential closeout points for short
positions. In the same fashion, traders
will sell their long positions or go short
following rallies to round-number levels like 85. Heavy open interest at these
strikes can emphasize this support or
resistance.
In the case of XOM, those who sold
the April 85 calls had a vested interest
to see the stock remain below 85, as
they were vulnerable to large losses if
the stock rallied above the 85 level.
These sellers can often induce resistance by adding selling pressure when
the stock approaches this critical level.

Likewise, put sellers have a major stake
in seeing the stock stay above the 70
strike so that their sold puts expire
worthless.
We should also note that these strikes
do not always act as precise resistance/support levels. This is often the
case when calls or puts build up on far
out-of-the-money strikes, as most of
the written options are unhedged
because of the low deltas for out-of-
Jon
Lewis
the-money options. However, as the
stock moves closer to the out-of-themoney strikes, those that sold these
options will feel more pain as the delta
increases and they are forced to hedge
their positions.
For example, those that sold calls may
begin buying the underlying stock,
March/April 2005
while those that sold puts may be

forced to short the stock. Delta hedging - the process of hedging more of
the underlying stock as it moves closer
to the strike price - can therefore result
in temporary surges through the strike
price.
When a weak stock (one for which
supply exceeds demand) overcomes
potential call resistance due to delta
hedging, the move will typically reverse
quickly back below the strike price as
hedging activity begins to decrease. On
the other hand, a strong stock will likely stay above the strike price as nonhedging demand continues to be
stronger than supply. Also, if there is a
significant penetration of the strike
price due to this heavy demand, additional demand from the delta hedging
process can add to the upside momentum.
The important lesson is that it is
advantageous to be aware of open
interest at various strike prices to know
why a stock behaves in a manner that
most other investors and traders do not
understand. Such knowledge can give
you the edge needed to give your portfolio a boost.
Jon Lewis is editorial director and
Todd Salamone is vice president of
research at Schaeffer's Investment
Research.
www.SchaeffersResearch.com
17
Techniques
18
March/April 2005
Techniques
SELL IN MAY
THE MONTH TO EXIT STOCKS?
by Ronald Doeswijk
he market adage 'Sell in

May' is one of the most
profitable, if not the
most profitable and simple
investment rule of thumb
available to investors.
It is profitable because, on average,

stock prices rise during winter. During
the summer, stocks, at best, perform
only as well as a savings account. It is
simple because all investors have to do
is to buy at the beginning of November
and sell at the start of May. Who said
investing was exciting? It seems to be
no more than rather tedious calendarwatching.
The seasonal pattern of stock markets occurs almost everywhere. Figure
1 shows the total returns for all
European country indices that go back
to 1970, as well as for the United States
and Japan. We define the winter period
as the six months from November to
April and the summer period as the
months from May to October. In only
three European countries is the excess
return, defined as the return on the
stock market minus the short-term
interest rate, positive during the summer period. These countries are
Denmark, Switzerland and Norway. For
all the other countries it would have
been better to sell equities at the start
of May and put the money in a deposit
account. In winter, however, the stock
March/April 2005
market is a much better alternative. On

average excess returns vary from
roughly 4% for Denmark to 12% for
Sweden. This seasonal pattern is not
just a European phenomenon - the
American and Japanese stock markets
also flourish in the winter.
The Sell in May effect is more than a
January effect. Figure 2 shows average
monthly returns. Here, we use an
unweighted average of the markets
used in Figure 1, i.e. Europe plus the
United States and Japan. As can be
seen, three months in the summer period show negative average excess
returns. January appears to be no more
than just a reasonably good month returns in December and April are
higher. The presence of a seasonal pattern in the stock market is clear, but we
are still left with the question of where
it comes from?
Although there is no consensus about
what causes it, the literature provides
three explanations for the Sell in May
effect. Firstly, there is the summer holiday-based
explanation.
Two
researchers, Bouman and Jacobsen,
showed that the size of the effect is significantly related to both the length and
the timing of vacations. However, they
believed that "arbitrage is a forceful
argument against this empirical link"
and that "it is still a mystery why stocks'
performance can oscillate so regu-
19
Techniques
14%
12%
10%
8%
6%
4%
2%
0%
-2%
-4%
Winter
US
Ja
pa
n
ly
Ita
De
n
S w ma
itz rk
er
la
n
No d
rw
a
Be y
l
g
Ne
iu
m
th
er
la
nd
G
er s
m
an
y
Au
st
r
S w ia
ed
en
UK
Sp
ai
n
Fr
an
ce
-6%
Summer
Figure 1. Total return from November through April (Winter) and from May through October
(Summer) from 1970 through 2004. Source: Morgan Stanley Capital International indices, IRIS
(Rabobank/Robeco)
larly."
Secondly, there is the winter depression explanation which attributes the
seasonal pattern to a risk-varying equity premium influenced by the Seasonal
Affective Disorder (SAD), the so-called
winter depression. This says that
depression lowers one's willingness to

take risk. So in the autumn the risk premium rises and prices fall, but as soon
as the days get longer, the risk premium
decreases and prices rise.
Thirdly, we have the optimism cyclebased explanation in which I argue that
the perceived outlook for the economy

and earnings varies during the year
according to a seasonal pattern. As year
end approaches, market participants
start looking forward to the next year
and are overly optimistic about the
growth prospects for the economy and
earnings. So, during the winter, the outlook for stocks is relatively good. This
pattern reverses around the time of the
summer lull in the stock market.
The winter depression theory has
received a lot of criticism, especially
because of its assumption that depression peaks in December. The optimism
hypothesis is new and has not yet been
discussed thoroughly within the investment community. The question as to
what causes the seasonality is a highly
interesting one. For investors, however,
the explanation is probably less of a
concern as history still suggests they
only have to take a look at the calendar
to determine whether to be over- or
underweighted in stocks.
3.0%
2.5%
2.0%
1.5%
1.0%
0.5%
0.0%
-0.5%
-1.0%
-1.5%
-2.0%
Jan
Feb Mar
Apr May Jun
Jul
Aug Sep Oct
Nov Dec
Figure 2. Average monthly total return 1970-2004 (Europe, US and Japan). Source: MSCI, IRIS
(Rabobank/Robeco)
20
March/April 2005
Ronald Q. Doeswijk is Global

Strategist at the Institute for
Research and Investment Services
(IRIS), research enterprise of
Rabobank and Robeco, the
Netherlands.
Techniques
Sell in May factsheet

Transatlantic distinction
One of the market's favourite sayings is "Sell in May and go away but buy back on St Leger Day". St Leger refers
to the classic horse race run every September since 1776 at Doncaster. In the US, investors are advised to hold out
for a bit longer - until Halloween on the 31st of October.
A long-standing observation
The Sell in May effect is not a recent phenomenon. Evidence shows that in a number of countries it has been
noticeable for a very long time, and in the UK - where the anomaly can be seen as far back as 1694 - the effect is
significant with 13.1 per cent return in the winter against 0.9 per cent in the summer months.
Emerging markets also seasonal
Looking at the period from 1970 to 1998, we found that the stock returns have been higher in the November-April
period than in the May-October period in 36 of the 37 established and emerging markets in our sample. In most
European and Asian markets the effect was strongly manifest. Even in the world's most efficient market, the US,
investors enjoyed 8.5 and 3.0 per cent respectively. Only in New Zealand was the anomaly absent.
Statistically significant
In a study published in the American Economic Review we showed that the economical and statistical significance
of this calendar anomaly is considerable. In 20 of the 37 stock markets we examined, the 'Sell in May' pattern is
statistically present at a 10% significance level, much more than pure coincidence. In theory stock market anomalies
shouldn't persist because they offer investors a free lunch and should be arbitraged away. But this anomaly does not
- at least not yet - seem to disappear or reverse itself after its discovery.
Trading Strategy
By switching to savings in May and buying stocks back around the end of October a British investor would have
enjoyed the winter market return plus six months' interest, giving an annualised return of 16.9 per cent from 1970
to 2004. By comparison, a 'Buy and Hold' investor would have enjoyed an average 12.5 per cent over the same period. With just two trades a year the superior returns are not being wiped out by transaction costs. This simple trading strategy would have outperformed a buy and hold portfolio in most countries we studied, and would also be
less risky because half of the time the assets are stored in risk-free savings deposits.
Although there are no guarantees this strategy continues to hold, the Sell in May effect is potentially interesting
for investors. For most professionals their mandate does not allow them to switch from cash to stocks and back
again like this. But by changing their asset allocation within the bandwidths they can still trade on it. Another
option is to use portfolio insurance during the May through October period. Pure equity investors can also benefit
from it by making adjustments to their style allocation, i.e. holding the more cyclically orientated stocks such as
industrials during the winter months and the more defensive sectors such as utilities and pharmaceuticals during the
summer months.
Sven Bouman is a senior portfolio manager at AEGON Asset Management in The Netherlands.
Ben Jacobsen is visiting professor at Massey University in New Zealand.
March/April 2005
21
Techniques
AN INTRODUCTION TO ICHIMOKU
by Gilbert Li
Traders in Europe are

hearing more and
more about the power
of Ichimoku charting.
So what is it and what
makes it superior to
traditional
techniques?
he Ichimoku Kinko Hyo

Japanese charting technique
was developed before World
War II with the aim of portraying - in a
snapshot - where the price was heading
and the right time to enter or exit the
market. This was all performed without
the aid of any other technical analysis
technique or study.
The word Ichimoku can be translated
to mean "a glance" or "one look".
Kinko translates into "equilibrium" or
"balance", with respect to price and
time, and Hyo is the Japanese word for
"chart". Thus, Ichimoku Kinko Hyo
simply means "a glance at an equilibrium chart", providing a panoramic view
of where prices are likely to go and the
position one should undertake.
Invented by a Japanese journalist with
a pen name of "Ichimoku Sanjin",
meaning "a glance of a mountain man",
Ichimoku charts have become a popular trading tool in Japan, not only with
the equity market, but in the currency,
bond, futures, commodity and options
markets as well. The technique was
published over 30 years ago but has
only gained international attention
within the last few years.
Calculation
The Ichimoku chart consists of five
lines. The calculation for four of these
lines involves taking only the midpoints
of previous highs and lows, similar to
moving average studies. Yet even with
this simplicity, the completed chart is
able to present a clear perspective of
the price action.
The five lines, as shown in Figure 1,
are calculated as follows:
1)
22
March/April 2005
Tenkan-Sen = Conversion Line

= (Highest High + Lowest Low)
/ 2, for the past 9 periods
Techniques
2)
3)
4)
5)
Kijun-Sen = Base Line =

(Highest High + Lowest Low) /
2, for the past 26 periods
Chikou Span = Lagging Span =
Today's closing price plotted 26
periods behind
Senkou Span A = Leading Span
A = (Tenkan-Sen + Kijun-Sen)
/ 2, plotted 26 periods ahead
Senkou Span B = Leading Span
B = (Highest High + Lowest
Low) / 2, for the past 52 periods, plotted 26 periods ahead
The Kumo, or cloud, is equal to the

area between Senkou Span A and B.
Ichimoku uses three key time periods
for its input parameters: 9, 26, and 52.
When Ichimoku was created back in
the 1930s, a trading week was 6 days
long. These parameters therefore represent one and a half week, one month,
and two months respectively. Now that
the trading week is 5 days, one may
want to modify the parameters to 7, 22,
and 44.
Interpretation
As can be seen from the formulas,
Ichimoku is very similar to moving
average studies. And like moving averages, buy and sell signals are given with
the crossover technique.
Figure 1. Definition of Ichimoku Kinko Hyo
A bullish signal is issued when the

Tenkan-Sen (orange line) crosses the
Kijun-Sen (purple line) from below.
Conversely, a bearish signal is issued
when the Tenkan-Sen crosses the
Kijun-Sen from above.
Moreover, there are, in fact, different
levels of strengths for the buy and sell
signals of an Ichimoku chart. First, if
there was a bullish crossover signal and
the price, at that time, was trading
above the Kumo (or cloud), this would
be considered a very strong buy signal.
In contrast, if there was a bearish
Figure 2. GBP/USD ProSticks Ichimoku Daily Chart
March/April 2005
crossover signal and the price, at that

time, was trading below the Kumo, this
would be considered a very strong sell
signal. Secondly, a normal buy or sell
signal would be issued if the price was
trading within the Kumo when the
crossover took place. Thirdly, a weak
buy signal would be issued if there was
a bullish crossover that occurred while
the price was trading below the Kumo.
On the other hand, a weak signal would
be issued if there was a bearish
crossover that occurred when the price
was trading above the Kumo.
Another striking feature of the
Ichimoku charting technique is the
identification of support and resistance
levels. These levels can be predicted by
the presence of the Kumo. The Kumo
can also be used to help identify the
prevailing trend of the market. If the
price is above the Kumo, the prevailing
trend is said to be up. And if the price
is below the Kumo, the prevailing trend
is said to be down.
A final feature of Ichimoku is the
Chikou Span. This line can also be used
to determine the strength of the buy or
sell signal. If the Chikou Span was
below the closing price and a sell signal
was issued, then the strength is with the
sellers, otherwise it is a weak signal.
Conversely, if there was a buy signal
and the Chikou Span was above the
23
Techniques
Figure 3. USD/JPY ProSticks Ichimoku Daily Chart
price, then there is strength to the

upside, otherwise it can be considered a
weak buy signal. This feature can also
be incorporated into the other signals.
Application
Most traditional technical analysis techniques are based on the open, high, low,
close or average price. Others may use
volatility while fixed scales such as
Fibonacci numbers have also been
applied. But the results are the same.
Support and resistance levels are always
depicted as a point or a line.
With Ichimoku charts, it is the Kumo
that quantifies support and resistance

levels and the Kumo that can be used to
project these levels into the future. It's
therefore important to note that (unlike
its traditional counterparts) the support/resistance level given by the Kumo
appears as a layer of varying thickness,
with the thickness being related to prior
market volatility.
Let's now illustrate the Ichimoku
technique with an example.
Figure 3 is an Ichimoku daily chart of
USD/JPY. Between August and
October 2004, the price was in a trading
range within the Kumo, which acted as
Short & long-term implications

One might wonder then what implications Ichimoku has regarding shortterm versus long-term trading. One
general application is that by comparing
a daily and a weekly chart, a price channel can be identified.
This can be illustrated with the
USD/JPY weekly chart in Figure 4.
One can quickly observe that the price
has been trading below the Kumo on a
weekly basis for the past two and a half
years. Comparing this with the daily
chart in Figure 3, one can see that the
price drop in October 2004 coincided
with the price hitting a strong weekly
resistance level.
So by comparing Ichimoku charts of
different time frame, one can gauge
where support and resistance levels
exist and then better position oneself in
the market.
This article only scratches the surface
of this wonderful charting technique
and as more charting applications provide this tool for traders, I believe that
most traders will not want to trade without it.
Gilbert Li is chief operating officer
at ProSticks.com
Figure 4. USD/JPY ProSticks Ichimoku Weekly Chart
24
a support level. At point A, the price

tested the bottom of the Kumo and this
support level held. Afterwards, the price
traded around this level before it surged
temporarily higher but failed to create
new highs. Soon after, the price retested
the low (point B) made by point A. This
coincided with a break below the Kumo
which has since narrowed (i.e. lower
volatility) and soon afterwards a huge
downtrend commenced once the previous lows were taken out.
In general, the thickness of the Kumo
can be related to the strength of the
current support/resistance level. A thin
Kumo implies the current volatility of
the market has lessened and the price
has been narrowed into a range that a
strong breakout to either side is imminent. On the other hand, a thick Kumo
implies a strong support/resistance
level coupled with high volatility.
March/April 2005
Techniques
MARKET TIMING
USING THE NYSE BULLISH %
by Dominic Hawker
Breadth indicators remain a simple and effective method

for measuring the strength of a market trend.
or the stock or index fund

investor, it is important to maintain a feel for the prevailing market conditions. Whether one pursues a
regular "buy and hold" or a more sporadic approach to stock investment,
one should always be aware of the
inherent risk and potential returns that
the market has to offer; and your
investment strategy should constantly
adapt to meet these conditions.
Market averages such as the Dow
Industrials or S&P500 indices are the
most readily available barometers for
market conditions. Using charts, it is
relatively straightforward to determine
the index trend and to identify how
long this trend has been in place.
However, of more benefit is an understanding of the underlying strength of
these market trends as this will go some
way to determining the likelihood of
the trend changing (and the relative levels of market risk). Breadth indicators
were developed precisely with this task
in mind: to determine the strength of a
market trend by looking at the trends of
its constituent stocks.
The NYSE Bullish %
The first breadth indicator, the NYSE
Bullish Percentage, was developed by
Abe Cohen, the founder of Investors
Intelligence in 1955. He was an early
pioneer of point & figure (p&f) stock
charts and these provided the ideal
building blocks for a market barometer.
By recording stock prices, p&f charts
effectively map out the relationship
between demand (buyers) and supply

(sellers). The advantage of p&f charts
is that these supply/demand imbalances are clear cut and easy to identify:
if demand outstrips supply, a p&f bull
signal is generated and if supply outstrips demand a p&f bear signal is generated.
Abe Cohen took the logical leap that
by calculating the percentage of bull
trends amongst the constituent stocks
of the NYSE index, he would have an
accurate picture of the supply/demand
relationship for the market as a whole.
For example, if there were 2000 stocks
in the NYSE index and 1000 of them

were on bull signals, then the Bullish %
would be reading 50%.
As it turned out, not only did the
NYSE Bullish % identify periods when
the bulls were in the driving seat i.e. the
best time to buy stocks, but it also
proved to be one of the best contrary
indicators for calling intermediate market tops and bottoms.
Using the NYSE Bullish %
Probably the best and most common
analogy applied to the NYSE Bullish %
is that of an American football
Figure 1.
March/April 2005
25
Techniques
Definitions of current market breadth status

Bull Confirmed chart is on a p&f
buy signal and is rising (column of xs);
and/or is in a column of xs above 68%.
Bear Confirmed chart is falling

(column Os) below 70% and has
generated a p&f sell.
Bull Correction chart is on a p&f

buy signal but is falling (column of
Os) without yet reaching 70%.
Bear Correction chart is on a p&f

sell but is rising (column Xs) without
having moved above 68%.
Bull Alert chart rising (Xs) moving

up from below 30% but has not yet
generated a p&f buy.
Bear Alert chart is falling from

above 70% to below 70% without
yet generating a p&f sell.
Bull Top - chart is falling (column of
Os) but above 70%.
Box 1.
game, where the level of the bullish %

represents the current field position
and the areas above 70% and below
30% are the "end-zones" (see Figure 1).
For a basic market strategy, think of
the play moving from one end-zone to
the other:
Low risk area below 30%: Almost
everyone who wants to sell has already
sold. Once the "play" starts moving up
from this area (indicated by reversals on
the p&f chart of the bullish %) it is

time to start playing the offense i.e.
aggressively buy stocks, even volatile
technology names and attempt bottomfishing in stocks at multi-year lows.
Mid-field: When the indicator moves
up into mid-field, continue to play the
offense but buy more selectively in
stocks with strong relative strength.
Begin to take profits in recovery plays
and holdings with weak relative
High risk area above 70%: When the

"play" starts moving down from this
area (indicated by reversals down the
p&f chart of the bullish %) it is time to
initiate defensive tactics. Sell any laggards (with weak relative strength).
Begin to tighten stop loss points on all
holdings. Focus new positions in defensive/lower beta sectors. Use ETFs
instead of individual stocks to reduce
volatility. Buy call options instead of
stock to limit equity exposure.
Signals from the Bullish %
Abe Cohen's original strategy for the
bullish percentage was to be bullish on
readings above 52% and bearish below
48%. However, as time went by, and the
back history of breadth data built up,
improved applications of this indicator
were introduced. Earl Blumenthal's
book "Chart for Profit", published in
1975, introduced a series of rules to be
applied to the point & figure chart of
the NYSE Bullish % or the "Bullish
Bearish index" as he referred to it. The
rules were further refined by Mike
Burke in 1982, when he became editor
of Investors Intelligence, and remain to
this day the recognised method of
applying breadth to market strategy.
There are seven market conditions
that can be derived from the p&f chart
of the NYSE Bullish % which are as
follows: (See Box 1)
Figure 2 shows the current p&f chart
for the NYSE Bullish %: the chart is
currently on a buy signal, hence showing bull confirmed status for the market. If the indicator were to move
down below 70% is would move to
bear alert status. A move below the previous down column of Os at 50%
would be required to move it to bear
confirmed status.
Alternative measurements of
breadth
In the early 1970s, Investors
Intelligence introduced further breadth
indicators that reflected the percentage
of stocks above their 10 week (50 day)
Figure 2.
26
strength. Buy new positions on pullbacks.
March/April 2005
Techniques
Figure 3.
and 30 week (150 day) moving averages.

These indicators provided an alternative method of defining a bull trend
and proved to be more sensitive to
market moves.
Figures 3 and 4 highlight the
increased sensitivity of the NYSE % 10
week moving average indicator compared to the NYSE Bullish %. Note the
sharp down-move that began in
January 2005 for the % 10 week indicator which has not yet been seen by the
bullish %.
Since their introduction, the moving
average based breadth indicators have
become the leading indicators, and the
role of the bullish % has become one
of a confirming indicator for medium
term trends.
Applying breadth to other
indices
The NYSE index, with over 2000 constituent stocks, remains a good broad
"universe" for measuring general market breadth. The NYSE bullish % has
now been calculated for over 50 years
and in the early days, before the dawn
of computers, was calculated using
hand-drawn p&f charts of the constituent stocks and adjusting the bullish
% figure for changes in the number of
stocks on bull signals. This extensive
back-history provides many precedents
Figure 4.
for signals generated in all sorts of

market conditions.
The Nasdaq was founded in 1971 as
an electronic marketplace for over the
counter (OTC) stocks and rapidly
developed as the home for emerging
technology and growth stocks. Breadth
indicators provide an excellent timing
tool for this market.
For small cap investors, breadth indicators based on the Russell 2000 and
Value Line Composite are the most
appropriate tools.
Breadth indicators are also available
for the S&P indices (Figure 5). This is
particularly useful as a timing tool for
"style" investors as one can compare
the breadth indicators for the large
Figure 5.
March/April 2005
27
Techniques
THE NYSE BULLISH % ... PROVED TO BE ONE OF

THE BEST CONTRARY INDICATORS FOR CALLING
INTERMEDIATE MARKET TOPS AND BOTTOMS.
cap S&P500, S&P Midcap 400 and the
S&P Small Cap 600.
The S&P
Composite 1500 index is a conglomeration of stocks from the three indices
and since it covers stocks from the
NYSE, AMEX and Nasdaq, provides a
viable alternative to the NYSE breadth
indicators.
Breadth and ETFs
The introduction of exchange traded
funds (ETFs) has provided investors
with an efficient vehicle for investing in
the above indices thereby offering
exposure to a diversified basket of
stocks that would be difficult to achieve
by direct stock investment. Using the
breadth indicators for the relevant
underlying indices can provide a valuable tool for the timing of ETF investments.
International markets
Investors Intelligence regional services
now offer breadth indicators covering
markets such as the UK (FTSE 100 or
FTSE All Share constituents), Europe
(the "All Europe" breadth indicators
measure breadth of all major European
index constituents), and Japan (the
Topix 100 or Nikkei 225 breadth).
Conclusion
The benefits of breadth indicators lie in
their use as a market risk measurement
tool and as a means of tailoring one's
investment strategy to meet the current

risk/reward characteristics of the market.
Whilst the Bullish % and other
breadth indicators were largely developed by the p&f community, we firmly
believe that this powerful form of
analysis should appeal to any investor
with market exposure.
Dominic Hawker is European analyst at InvestorsIntelligence.com
and a director of Stockcube
Research Limited. The Investors
Intelligence site displays breadth
charts in a variety of formats for all
major stock markets.
www.investorsintelligence.com
Subscribers benefit from an online charting package (with no troublesome software to install)
plus regular analysis updates from the Investors Intelligence team, including:
1,000s of online charts: P&F (with user-definable scales), candlestick, line and bar plus indicators
Automated daily point & figure breakouts
Index and sector breadth analysis (as featured in this months article in TA magazine)
Long/short Chart of the day
Model portfolios
Investors Intelligence (UK) is a division of Stockcube Research Limited, authorised and regulated by the FSA.
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Techniques
MEASURING THE STRENGTH OF

SUPPORT AND RESISTANCE by Erich Senft
here is a world of difference

between guessing where the
market might be going and letting the market tell you where it is
going. Knowing how to handle support
and resistance - price levels at which
excess supply or demand can be
expected to temporarily halt or even
reverse price direction - is the key.
Since the market tends to move from
one support and resistance level to
another, knowing where these levels are
gives us an idea of where the market is
heading next. Furthermore, being able
to quantify the strength of support and
resistance will give you some guide as
to whether price will steam through
these levels or rebound off them.
Might makes right
The strength of a support or resistance
level is determined by how many times
the market tests that particular price.
Each time the price has been hit by
either a high or a low it counts as one
point towards the strength of the
resistance level. The more times a support or resistance area has been tested
the harder it becomes.
Therefore if you have a price that has
been tested 5 times as support and
another price that has been tested 3
times as resistance, then the market will
likely break through the resistance (3)
since it is not as strong as the support
(5).
This is a basic premise of trading support and resistance: that all things being
equal, the market will always choose the
path of least resistance. However, factors such as the overall market trend,
long term support or resistance and
overbought/oversold status means that
things are not always equal.
Weighting support & resistance

While each occurrence, or "hit", of
support and resistance counts as one
point towards the overall strength of
the resistance level, some types of support or resistance are stronger than
others and therefore require special
consideration. In fact the biggest mistake traders make is assuming that all
support and resistance are created
equal. They are not.
Factors such as exact and/or round
numbers, contract highs and lows as
well as significant retracement levels
like Fibonacci 38%, 50% and 62%
retracements all serve to add strength
to support and resistance in question.
Generally speaking, I consider such levels to increase the strength of the
resistance by 50%.
Using the weekly crude chart in
Figure 1 as an example, we can see that

there are four hits at the high of 55.20
(15 October 2004 at 55.00; 22 October
2004 at 55.17; 29 October 2004 at
55.05; and 4 March 2005 at 55.20).
However this resistance does not simply count as 4 hits, rather it is much
stronger than that.
The resistance occurs at the contract
high, which is a very significant price
barrier in the life of a commodity. The
market requires a great deal of momentum in order to exceed such a level.
Therefore we would add another 50%
to the original 4 hits to represent the
strength of the contract high.
Therefore our 4 hits have the same
strength as if this price had 6 hits.
Likewise the resistance is occurring at
the neckline of a rounded bottom formation. Again the neckline repre-
Figure 1.
March/April 2005
29
Techniques
Identifying Support and Resistance

Identifying support and resistance is
not quite as difficult as some people
make it out to be:
Support or resistance occurs when
you have two or more highs, lows,
opens, closes or combination
thereof, occurring at, or close to,
the same price. When the daily values intersect at a particular price,
this forms support or resistance.
Consider opening and closing
prices along with the highs and
lows of each price bar. While the
highs and lows represent the limits
of both the buyers and sellers, the
opening and closing prices show
prices to which the market is especially sensitive.
Prices form two types of support
and resistance:
1. Exact price resistance - when the
highs and/or lows meet at an exact
price
2. Price zone resistance - when the
highs and/or lows are close
enough in price to act as support
or resistance but are not exact.
tight with their support and resistance figures.

To determine if prices are "close
enough", look back to see where
the market has reversed off of
support or resistance in the past.
By examining how close prices
were when the market reacted
before, you get a feel for how close
prices need to in the future.
Because resistance is often in the

form of a price zone, many traders
make the mistake of being too
In a market like crude oil for

instance, prices within 10 cents
would be considered close enough
to count as resistance. For exama
sents a significant resistance barrier and

as such we need to add another 50% to
our resistance value in order to accurately represent its strength. In other
words our original 4 hits represent the
same strength as if the price had 9 hits
on it.
Any support or resistance level that
does not score at least a 5 using this
method is likely not strong enough to
affect the market and can be ignored in
your analysis.
Does this mean that the market has to
reverse off these levels? No, it does
not, but what our support and resistance analysis does tell us is what the
market is most likely to do when it

approaches these areas of heavy resistance.
We need to consider other factors
such as the seasonal tendencies of the
market, the strength of the trend, and
whether prices are overbought or oversold before we can make an accurate
prediction as to whether the resistance
will cause a full reversal or merely a
pause in the trend.
However, knowing that a significant
resistance barrier is nearby allows you
to better time your market entry or
postpone your entry altogether until
you can see how prices react to the
30
March/April 2005
ple, if we saw May crude trade at

49.00 and 49.10, these two prices
would count as two hits on the
same resistance level.
As a rule of thumb, the daily chart
parameter is normally doubled for
weekly and monthly charts.
Therefore if 10 cents is close
enough to count as resistance
between values on a daily chart,
then the criteria would be expanded to include values which are 20
cents apart on weekly and monthly
charts.
resistance in question. Likewise if you

are in a trade and see the market
approaching an important resistance
area you can tighten your exit stops or
exit with a profit taking order.
As such, identifying and quantifying
support and resistance levels is one of
the best ways of achieving superior
market timing and for keeping risk
exposure as small as possible. Using
support and resistance moves trading
from the area of prediction into the
field of management.
Erich Senft, CTA, is director of
www.supportandresistance.com
Techniques
SWING TRADING WITH FLOAT CHARTS

by Steve Woods
Float Charts are a new and unique way to track a stock's trading behaviour. And
one profitable way of using them is to look for ABC Float set-ups.
loat Charts are the only charts

that use all four available pieces
of stock data: price, volume,
time and the float.
The term float refers to the number
of shares actually available for trading.
When a company goes public they issue
shares outstanding. The management
then holds some percentage of shares
and what's left over to be sold to the
public is called the float or floating supply. Float Charts are all about tracking
the floating supply in an attempt to find
areas of accumulation and distribution
on the chart due to a change in the
ownership of the floating supply.
There are three other terms that are
key to constructing and analyzing Float
Charts: Float Turnover, Float Boxes,
and Float Channel Lines.
Float turnover refers to any time
frame on the chart in which the cumulative volume equals the number of
shares in the floating supply. Float
turnovers are shown on the chart as a
gray rectangle with two red lines. The
rectangle changes from day to day like a
moving average and is known as the
Float Turnover Box or more simply the
Float Box.
The upper and lower right hand corners of the Float Box get plotted on a
day-to-day basis thereby creating Float
Channel Lines. These channel lines
allow us to see the "tracks" left behind
from previous float turnover boxes in
the past. By creating Float Boxes from
1/2 or 1/4 of the floating supply we
get narrower channel lines within the
larger 100% Float Box Channel lines.
These narrower lines known as the
50% and 25% float channel lines show
where stocks have a tendency to find

support at the bottom of corrections.
These are the lines that create the ABC
Float Set-Ups.
To understand Float Boxes more
clearly let's study an example of one of
my best winners in the November
Election Rally of 2004 in Figure 1. At
that time Parlux Fragrances (PARL)
had 7.3 million shares in its float. To
create its current Float Box we simply
add today's volume with yesterday's
volume and that total with the volume
of the day before that and continue a
cumulative sum until the total in the
backward count reaches 7.3 million. At
the time of this writing, it took 25 days
to trade 7.3 million shares. Thus its
Float Box is a rectangle going back 25
days. The top and bottom line of the
Float Box are created by finding the
highest and lowest price in the backwards count which
in its current box is
$24.92 on the high
side and $19.30 on
the low side.
Float Boxes
change from day
to day much like a
moving average.
The Float Box size
gets recalculated
every day as the
new volume number is used to
determine how far
back the box will
extend.
Now
think of the box
moving to the
right and as it does Figure 1.
March/April 2005
so imagine the upper right hand and

lower right hand corners being plotted
on a day-to-day basis. The upper and
lower right hand points are thus used to
create the upper and lower float channel lines.
Now imagine a box that is created
using half the Float number (or one
fourth the number).
For Parlux
Fragrances this would be half of 7.3
million or 3.65 million (one fourth
would be 1.83 million). Now imagine a
smaller box with its own upper and
lower channel lines. These channel
lines are called the 50% Float Channel
Lines because they're created using a
box that is 50% the size of the full
Float Box (or the 25% float channel
lines if using a value of 25%). Now
take away the 50% box (or 25% box)
but leave the 50% channel lines (or
25% line) and you have a Float
31
Techniques
Figure 2.
Figure 3.
Chart. Figure 1 shows PARL with

Float Box, channel lines and 50% Float
Channel Lines. Note that I've included
the 50% Float Box for demonstration
purposes only as ordinarily this box is
hidden from view and we only know it
is there by the dotted channel lines
which are its tracks.
What is important at this point is to
think of three different sized boxes
moving forward in time but capable of
moving backwards as well. Remember
that as the three Float Boxes move forward from one day to the next, their
upper right and lower right hand corners create the channel lines. Moving
the boxes backwards is helpful as it
allows you to analyze past price, volume, float and time formations.
Currently there is only one piece of
software that allows the box to be freely
moved backwards through time and
that is the V2 Charting software created by www.StockSharePublishing.com.
One final but important point concerning Float Boxes and Float Channel
Lines is the method for plotting them
on price penetration days. Let's say a
stock has been trading sideways for several weeks and the top of the Float Box
(the upper red line) is at $25 and the
bottom of the Float Box (the bottom
32
red line) is at $20. Now let's say the

stock finally penetrates above the top
red line and makes a new high of $27.
On this penetration day, we don't want
the top red line to be placed at the new
high of $27. If it was placed there,
then we wouldn't be able to see that the
breakout had occurred. Instead we
want the line at $25 to remain there so
that a penetration is actually visible.
What gets sacrificed is the actual size of
the Float Box on the day of the penetration. The actual size should be
based on the new high that has just
been reached. Figure 2 illustrates this
important point.
ABC Float set ups
Any one who takes the time to look at
a large number of Float Charts will find
one striking discovery that is seen again
and again. Prices in up-trends tend to
find support near their 50% or their
25% Float Channel Line. It is easiest to
see this on a Float Chart with the Float
Box removed, so let's look at a few
examples.
I prefer random sample demonstrations of Float Charts so I've chosen the
first three charts that are mentioned in
the table "NASDAQ Where the Big
Money's Flowing" on page B6 of the
March/April 2005
Investor's Business Daily on January

28th (the day this article was written) these are Affymetrix (AFFX), Digital
River (DRIV), and Websense (WBSN).
Now let's look at their charts and see
if support came in at or near either the
50% float channel line or the 25% float
channel line at any point on the chart.
Affymetrix (AFFX) (Figure 3)
From its August 2004 low ($24.48) to
its January 2005 high ($41.96)
Affymetrix found support right at its
25% Float Channel Line twice. Once
on October 12th ($28.89) and once on
January 4th ($33.94). Both occasions
marked the low of the month.
Digital River (DRIV) (Figure 4)
From its August 2004 low ($22.75) to
its December 2004 high ($44.51)
Digital River found support right at its
50% Float Channel line once - on
November 4th ($31.08). This point
marked the bottom of its deepest correction in its run to the upside.
Websense (WBSN) (Figure 5)
From its August 2004 low to its
December 2004 high, Websense found
support twice just under its 50% float
channel line.
Techniques
Figure 4.
Figure 5.
PRICES IN UP-TRENDS TEND TO

FIND SUPPORT NEAR THEIR 50%
OR THEIR 25% FLOAT CHANNEL LINE.
One striking characteristic of the 50%
and 25% Float Channel Lines is their
dynamic quality. It is a mistake to think
of the 50% lines as being 50% of the
distance between the top and bottom
of the 100% Float Box. The channel
lines have their basis in volume numbers not prices and can create levels
that are unrelated to any past price
level. Thus the lower 50% float channel line may actually show up near the
top 100% float channel line or the near
the bottom 100% float channel line. It
all depends on the new volume data,
which obviously changes from day to
day. The fact that prices find support
and resistance at different percentage
levels within the float turnover is one of
the great discoveries of Float Analysis
and needs further explanation.
In order to make money with these
ideas, I use a simple ABC price swing.
The model is very simple and yet very
powerful. The idea is that prices tend

to move in a three-wave sequence: an A
Wave Up, a B Wave Down, and a C
Move Up again. Thus in using this
model to trade, we let the market show
us strength with price and volume in
the A Wave, then we want to see the
volume dry up in the B wave down to
the 50% Float Channel Line and then
just as the price begins to move back up
we jump on board for a profitable C
Wave. By using the 50% Float Channel
line to help us find the turning point
which begins the C Wave, we look for
high probability entry points. Our daily
and weekly scans find the stocks that
are turning around and heading higher
right at or just below the 50% level
which is the start of the profitable C
Wave. We simply buy into the price rise
on those stocks that we see as having
the highest likelihood of continuing to
move on up.
March/April 2005
Float Charts are a new and powerful

tool in the search for profitable trading
and although they are not as widely
known, used or understood as other
charting methods, they are an important development in the history of
charting.
Steve Woods is a professional trader

and CEO of www.FloatCharts.com,
an independent stock charting and
market analysis service based on the
ideas found in his book Float
Analysis (Wiley, 2002).
Note: The origin of Float Charts and their analysis

goes back to the writings of W.D. Gann. See Gann,
W.D. (1976), Truth of the Stock Tape, LambertGann Publishing, Pomeroy, WA and my book:
Woods, Steve (2000) Float Analysis, Wiley & Sons,
New York, NY
33
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Interview
THE TECHNICAL ANALYST TALKS TO

Murray Gunn
Murray Gunn is investment director of
currencies within the Treasury division at
Standard Life Investments in Edinburgh.
He has also worked as a bond and currency
strategist at Standard Life and was previously
a fund manager with Hambros in London.
TA: What do you do at Standard Life Investments?
MG: I am responsible for currency dealing, position taking
and, along with others, the currency strategy for Standard
Life Investments funds. Most of what I do is involved with
managing the currency risk in-house but I also get involved
with speaking to clients and pitching for new business.
We manage currency risk in different ways depending on
the mandate of certain funds. Some funds only take naked
currency risk, some funds are fully hedged and some are a
hybrid of both. The currency risk that I am actively managing involves only the major and secondary currencies at the
moment.
TA: To what extent do you use TA on a daily basis?
MG: Technical analysis is the bread and butter of my daily
routine. I pay attention to the market buzz because I believe
it is good to know what the market is focusing on, whether
that is economic figures or other currency related news but
for me, price action is of paramount importance.
The great thing about currencies is that they are driven by
all sorts of different factors so a currency specialist has to
have his finger on the pulse of what stocks, bonds and
commodities are doing as well as the political and economic
news. I think this is one reason why technical analysis is
very suited to currencies.
Price action will reflect the consensus of how all these
different factors are being perceived by the market so that
at any one time we can see whether the bulls or the bears
are in control. For me, this is what technical analysis is all
about. It is not about "oneself" being bullish or bearish; it is
about working out who is in control of the market, the
bulls or the bears, and managing your risk accordingly.
So, to answer the question, my daily routine involves
using technical analysis constantly over different time scales
to answer this question.
36
TA: Which TA techniques and studies do you use on a regular basis?

MG: I am a trend follower and proud of it. It always
amazes me how some people disdain the phrase 'trend following' because everyone who ever made any money out of
the markets has done so by following a trend of some
description. If you are looking for turning points in the
market or even if you base your decisions on fundamental
analysis then you are doing the same as someone who
trades breakouts. You are looking for a continuation of the
price in the direction you traded!
My preferred method is based on the Alexander Elder
multiple timeframe method whereby you establish the long
term trend first and then trade one timeframe down in the
direction of that trend. So I will measure the long term
trend based on weekly moving averages and the short term
momentum based on the daily MACD. If the long term
trend is up then I am only looking for MACD buy signals
and vice versa if the long term trend is down. I will alter
March/April 2005
Interview
my position size based on the position of the MACD oscillator and a volatility measure.
I prefer this type of non-continuous trend following
method to one where you are in the market all the time
because, although you will make money over the long term
using that method, you could also get chopped to death by
non-trending market conditions.
The drawback with this method is that you could miss
some big opportunities when the long term trend is in the
process of turning. For this reason I also look for divergences between price and MACD. So if the long term trend
is currently up but the daily MACD has given a sell signal,
whereas normally I would ignore this sell signal, if it is also
exhibiting bearish divergence then I go short. This should
mean that I am covered if the daily divergence leads to a
turn in the long term trend.
TA: Do you make any distinction between short-term and
long-term analysis?
MG: The method Ive just described makes use of long and
short term analysis. I think this is possible if you are using a
mechanical or semi-mechanical process but I think it
becomes more difficult when using discretionary techniques
such as pattern recognition. For example, if the weekly
chart is showing a double bottom but the daily chart is
showing a double top what do you do? In my experience
you can end up with too much confusion. I prefer to stick
with one time frame if I look at discretionary technical
analysis techniques but I will use multiple time frames for
more mechanical techniques.
TA: How much do you consider fundamentals?
MG: At the currency overlay or active currency management level our approach is to manage the risk based on
style diversification and risk budgeting. So my colleague
who is more fundamentally based will manage some risk
based on that style and I will manage some risk based solely
on technical analysis. This approach works well because
each style is relatively uncorrelated. As we know, when the
technicals are bullish then the fundamentals can be bearish
and vice versa. Style diversification is a way of recognising
this and is a prudent method of risk management at the
portfolio level.
TA: Which software do you use?
MG: I use Bloomberg generally and TradeStation for
research and testing.
TA: How many at SLI are using or are involved with TA
either on the FX, fixed income or equity side?
techniques. Indeed, our strategy desk use it as an important

input into our house view process for asset allocation.
Generally, most asset classes will use technical analysis (or at
least a recognition of price action) in their investment decisions. It fits well with our Focus On Change investment
process at SLI because we are constantly asking ourselves
questions to find market drivers and market triggers.
TA: Are there any technical analysts that you admire in particular and any publications that you rely on?
MG: Early on in my career when I was at Hambros I sat
next to Tony Plummer who influenced me greatly. His academic approach has kept me interested in the theoretical
aspects of technical analysis. I'm always interested in what
Richard Russell has to say on Dow Theory given his vast
experience and I listen to what Robert Prechter has to say
on long term Elliott Wave theory. I also admire the work of
Redtower Research, based here in Scotland.
TA: Are there are any recent developments in TA that have
interested you?
MG: I think the work done by Michael Covel at Trend
Following is interesting. He brings the subject much more
into the open and dispels some myths about hedge fund
"black boxes". I think the investing public will be amazed
by how such superb long term returns have been generated
by such a simple technique. I am also very interested in the
Socionomics Foundation that Robert Prechter has set up to
further research into social trends because this whole subject is what links technical and fundamental analysis together.
TA: Does being located outside the City of London make
any difference to the acceptance and use of TA? For example, is TA less widely used in the financial district in
Edinburgh than in London?
MG: One of the best aspects about using technical analysis
is that it doesn't matter where you are based as all a technical analyst needs to know is the objective data. We have a
number of members of The Society of Technical Analysts
in Scotland and we meet up from time to time to discuss
our techniques and research.
The Scots financial community tends to be more biased
towards fundamental analysis although there are pockets of
people that use technical analysis a lot. I think there is still a
view that technical analysis is useful only for the short term
and this is one reason why it has difficulty being accepted
fully by long-term investors. It is up to us as technical analysts to point out that market psychology is just as relevant
for long term investing as it is for shorter term trading.
MG: There are a number of people across the company

who have an active interest in, and use, technical analysis
March/April 2005
37
Subject Matters
NEW THEORETICAL LIGHT FOR

TECHNICAL ANALYSIS by Kian-Ping Lim
Does technical analysis have any solid theoretical foundation in the academic
literature? The author argues in favour of an important new theory to underpin TA Adaptive Markets Hypothesis.
he
Efficient
Markets
Hypothesis (EMH) has been
the guiding light in the field of
economics and finance for the past few
decades. So much so that any findings
that contradict it have been dismissed
as statistical anomalies.
Yet the theory no longer receives
resounding acceptance among seasoned practitioners who continue to
explore ways to exploit predictabilities
in the stock markets. One of the techniques widely employed by professionals in the investment world is technical
analysis - a practice dismissed by disciples of EMH who hold on to the belief
that patterns observed in the past
occurred by chance.
In recent years, the pendulum has
swung in favour of professional analysts with more and more evidence of
stock market predictability being
reported in the academic literature. In
fact, in 1999, John Cochrane, professor
of finance at the University of Chicago,
labeled stock market predictability a
'new fact in finance'.
The search for a theoretical explanation for predictable patterns has been a
challenging one. Up to now, the field of
behavioural finance has been most successful in providing plausible explanations, to the extent that behavioural
finance has proved a natural academic
ally for technical analysis. It now seems
normal to marry the two together with
the idea that charts are the graphical
representation of market psychology.
However, EMH still survives. This is
38
because evidence reported in the academic literature does not lean cleanly
towards either side - behavioural or
classical economics - and this has further hardened the resolve of proponents on both sides.
In an article that appeared in the
September/October issue of The
Technical Analyst, I attempted to offer
reconciliation to the controversy
between proponents of EMH and
advocates of technical analysis. Using
daily data of South Asian stock market
indices, I demonstrated that there were
times when the markets moved randomly and other times when the market moved in a significantly non-random and dependent pattern. In this
regard, during those periods when the
markets moved non-randomly, it was
possible for investors to devise a trading rule to exploit these linear and nonlinear dependencies to earn abnormal
rates of return.
The statistical exercise I carried out
revealed that the mixed evidence on
efficiency/ inefficiency documented in
the academic literature was not surprising. I found that there were times when
the market was efficient and times
when the market was predictable. Using
the same analysis on the same market, it
could be seen that different time periods gave contrasting results. The main
message that emerged was the importance of market timing strategies, since
predictability is mainly a short-horizon
phenomenon with predictable patterns
appearing only sporadically.
March/April 2005
Though my work threw important

light on the controversy between EMH
and technical analysis, it lacked any
solid theoretical framework to justify
the findings. But subsequent to my
study, a new theory has emerged that
fills this theoretical void - the "Adaptive
Markets Hypothesis" (AMH), proposed last year by Andrew Lo, professor at MIT Sloan School of
Management. The potential importance of this theory was underlined by
its publication in a special 30th anniversary issue of the Journal of Portfolio
Management.
The theory is heavily influenced by
recent advances in the emerging discipline of "evolutionary psychology".
This new paradigm, which is an alternative to the classical EMH, is based on
the principle of evolution where competition, adaptation and natural selection determine the efficiency of markets and the waxing and waning of
financial institutions, investment products, and ultimately individual fortunes.
AMH offers a number of concrete
implications for the practice of portfolio management. Firstly, contrary to
classical EMH, profit opportunities do
arise from time to time in AMH. The
very existence of active liquid stock
markets implies that profit opportunities must be present. This is not surprising - researchers have long argued
that perfectly efficient markets are an
impossibility, for if a market is perfectly efficient, there is no profit earned by
information gathering, in which case
Subject Matters
there would be little reason to trade and

markets would eventually collapse.
Thus, in practice, there must be sufficient profit opportunities to compensate investors for the cost of trading
and information gathering. From an evolutionary perspective, these
predictable
patterns
should not persist over
time because they will
disappear after identification and exploitation by
investors, but new
opportunities are continually being created as
groups of market participants, institutions and
business conditions all
change.
Lo presents an illustration of this process:
"those investors
who experienced substantial losses in the technology bubble are more
likely to have exited the
market,
leaving
a
markedly different population of investors today
than four years ago.
Through the forces of
natural selection, history
matters."
Hence, contrary to the
inexorable trend towards
higher efficiency as predicted by classical EMH,
AMH implies considerably more complex market dynamics, with
cycles, trends, panics,
manias, bubbles, crashes,
and other phenomena
that are routinely witnessed in natural
market ecologies.
To support his point, Lo computed
the rolling first-order autocorrelation
of monthly returns of the S&P
Composite Index from 1871 to 2003, a
method for determining how much
interdependency there is in a price
series. According to classical EMH, the
first-order autocorrelation coefficients
were expected to take on larger values
during the early part of the sample and

become progressively smaller in recent
years as the US equity market became
more efficient. Against the expectation
of EMH, the graphical plot instead
demonstrated that the degree of efficiency varied through time in a cyclical

fashion, with the surprising result that
the market was more efficient in the
1950's than in the early 1990's - a finding consistent with AMH.
Moreover, it's possible that Lo himself underestimates the level of predictability in prices. His study assumes
that a lack of autocorrelation means a
price series is unpredictable, yet the
March/April 2005
method he employs is only capable of

detecting linear dependencies. In this
regard, the (windowed-testing) procedure that I and others have used is
superior because it can also uncover
non-linear dependencies
- this is the statistical
equivalent of being able
to spot chart formations
such as head-and-shoulders.
Secondly, investment
strategies will wax and
wane, performing well in
certain environments
and performing poorly in
others. Specifically, AMH
implies that investment
strategies undergo cycles
of profitability and losses in response to changing business conditions,
the number of competitors entering and exiting
the industry, and the type
and magnitude of profit
opportunities available.
As such, the Adaptive
Markets Hypothesis provides a solid theoretical
basis to explain why
there appears to be times
when technical analysis
works and times when it
does not. This calls for
active
management
strategies and justifies
the application of technical techniques in stock
market investment - the
success
of
which
depends on the ability to
time the market.
AMH could well be the
theoretical foundation that technical
analysis has been missing. Only time
will tell whether it can make important
inroads into the financial mainstream.
Kian-Ping Lim is a lecturer in the

Labuan School of International
Business and Finance, Universiti
Malaysia Sabah, Malaysia.
39
Software
TRADERMADE404 & THE CUBE

Financial institutions are forever striving for more
flexibility from technical analysis software solutions.
Here we present two of TraderMade's latest product
releases that have been designed to meet these
demands - The Cube and TraderMade404.
The Cube
In an ideal world, dealers can sit at any desk within the
dealing room and have access to all of their applications
and personal settings. Portability and flexibility is what is
required, but this really means using browser-based applications. However, the problem with such web-based technical analysis systems is that they have simply not been up
to the specification required by institutional users.
TraderMade, a UK company that has been providing
technical analysis solutions to the financial markets since
1985, has finally bridged that gap with a brand new product called The Cube.
As its name suggests, The Cube has been designed as a
container for whatever market information you want to
display. The package includes customizable quote boards,
news, plus comprehensive technical analysis studies. These
include:
Moving Averages, Bollinger Bands, Parabolics and
Weekly Rules.
RSI, Slow Stochastics, MACD and DMI.
Extensive line drawing options, including channels,
Fibonacci retracements and fans.
major asset classes (bonds, futures, FX, commodities,

deposits, stock indices and shares). All of this data has
been checked and cleaned so that the charts are complete
and accurate, free from spikes and gaps, with more than 20
years of back data available for most instruments.
Clean data ought to be a given in this day and age, but
many TA systems continue to be badly let down in this
area. But even if you want to keep to your existing data
provider, The Cube allows you to incorporate your own
market data or news feeds, effectively using the front-end
product only.
In summary, The Cube offers a high level analytics package in a
flexible, portable web-based application.
Each user can construct and save their pages exactly how
they wish. They can then access the application and their
settings from any internet PC in the world.
Since The Cube is a java applet accessed through via
internet, it requires no software installation and can run on
any internet PC. This also makes it an ideal low-cost solution for disaster recovery provision.
One potential issue is that, in the fast moving world of
Java programming, Java applications can clash with each
other when using different Java plug-in versions.
TraderMade has solved this issue and can support the
application running in a multiple Java plug-in environment.
As well as designing the analytical front-end,
TraderMade also provides the raw data, covering all the
TraderMade404
TraderMade404 replaces the existing TraderMade
Workstation range. With additional functionality and new
optional services, the 404 fulfills the requirements of the
most demanding of TA users.
TraderMade404 is available in five different levels. While
the 404 Lite offers an abundance of TA tools, users can
upgrade to Standard, Intermediate, Advanced or
Professional levels to fit their exact needs and budget. But
despite this depth of functionality, the product is remarkably easy to use.
At the most basic level, users can build and save unlimited chart pages. Most actions can be performed using
drop-down menus, button bars or the keyboard, so users
can choose their favorite method of getting around the
40
March/April 2005
Software
"UP UNTIL NOW, PROVIDERS HAVE

NOT BEEN ABLE TO TRANSLATE THEIR
SOFTWARE APPLICATIONS TO THE
INTERNET WITH ANY GREAT
SUCCESS. THE CUBE IS THE FIRST
PRODUCT TO CRACK THIS DILEMMA."
PADDY OSBORN, TRADERMADE
system.
TraderMade's Microsoft Certified Partner status has
allowed them to structure the product with familiar functions and actions such as copying and pasting charts or
linking data feeds to Excel.
At the top of the range, the 404 Professional offers
some important extras for the advanced user. These
include:
Programming - The ability to build your own analytical
tools. Fully programmable in VB Script, the 404 can be
used to manipulate TraderMade's historical database.
Proprietary models can be constructed within the system or copied from Excel spreadsheets. The results can
then be displayed on a chart to illustrate the profitability of any particular model. For an additional cost,
TraderMade also offers programming solutions for you.
Data Download - unlimited access to the TraderMade
proprietary database, allowing downloads of data as far
back as 1981.
Short-Term Trend Indicator - This is an intra-day proprietary trading model which has been generating profitable returns in the four major US Dollar crosses for
over 15 years. It holds no overnight positions, but gets
into the market as soon as a trend is detected each day.
Although TraderMade has traditionally been perceived as
a tool primarily for the FX markets, the 404 offers
March/April 2005
enhanced features and data manipulation particularly

designed for futures users. This includes flexible contract
rollover dates for continuation charts; default front, 2nd,
3rd-month contracts etc.; volume indicators; and spreads
and butterflies - giving a truly bank-wide solution for market analytics.
With regard to data, the 404 feeds off the same
TraderMade databases as The Cube and therefore offers
the same advantages that come with good quality clean
data. However, recognising the fact that the breadth of
TraderMade's databases may be insufficient for some institutions, external data sources can be fed into the 404
instead (as is also the case for The Cube).
Institutional users who regularly communicate with
external clients (or other dealers) may also wish to add-on
TraderMade WebLink. WebLink enables analysts to broadcast their charts and opinions to clients in real-time with
all charts up-to-date and time-stamped - an important tool
for presenting consistent information both in-house and
to external customers.
In summary, TraderMade offers a full suite of charting products,
from specialized high-end applications to white label solutions for
large audiences, all fed by the same high-quality data feeds. While
offering something for everyone, TraderMade expects The Cube and
TraderMade404 to make a significant impact in the market over the
coming months.
Paddy Osborn is a director of
International.
TraderMade
41
Book Review
THE PSYCHOLOGY OF
THE FOREIGN EXCHANGE MARKET
The Psychology of
the Foreign Exchange Market
By Thomas Oberlechner
John Wiley & Sons Ltd
258 pages, 45.00
ISBN 0-470-84406-X
The Psychology of the Foreign

Exchange Market is available from
the Technical Analyst bookshop at
the reduced price of 31.50 plus
2.00 P+P. To order please call
01730 233870 and quote "The
Technical Analyst magazine".
Books are usually posted within
one working day of your order.
42
oreign exchange traders are likely to talk about the market in terms of their lover,
an ocean and a war zone, says Thomas Oberlechner, professor of psychology at
Webster University, Austria.
If this is a surprise to you - and if you still believe traders act as the rational "agents"
assumed by classical economic theory - then you'll find plenty more to astound you in
the rest of "The Psychology of the Foreign Exchange Markets".
If not, then expect to see the following recipe: Take two surveys (of 791 FX traders
and 75 financial journalists), shoehorn mixture into popular behavioural finance cake tin,
bake in a medium oven for 200 odd pages, and cover with icing made of academic rigour
and scrutiny.
The good news is that once you come to terms with the sense that the author has
forced the facts to fit current theory, there are enough gems in there to keep you reading
on.
The findings from his surveys are well organised and vividly illustrated; and the results
are discussed with reference to many interesting psychology experiments. For example,
the idea of herding is illustrated by an experiment where nine participants were asked to
match the length of an original line to one of three comparison lines, two of which were
clearly the wrong length. They were then asked, in turn and in front of the others, to
choose the correct comparison line. What the ninth person didn't know was that the
other eight participants were told to give the wrong judgment. The ninth person duly followed with an incorrect answer; despite the fact the right answer was obvious.
Such experimental examples are entertaining and insightful about human nature. But
Oberlechner's conclusions are vague and sometimes even stunted, and you are left trying
to puzzle whether all this will be any help to you as a trader. Part of the problem comes
from the fact that Oberlechner finds it hard to move on - even on page 192 he is still trying to persuade us of something that he already persuaded us of seven chapters ago, i.e.
that economic models cannot successfully explain the FX markets.
The chapter on "Expectations in the Foreign Exchange Market" is particularly good
for anyone trying to demonstrate the widespread use of technical analysis as a forecasting and trading tool. His survey showed that on a scale of 1 to 10 where 1 equals the use
of pure TA and 10 equals the use of pure fundamental analysis, traders on average gave
a ranking of 3.47 for intraday trading, 3.77 for one week, 4.40 for one month, rising to
6.79 for over one year.
Also of interest, although not much of a surprise, are his findings about the extent to
which fundamentals and technicals are combined. Oberlechner's European survey
reveals that over 60% of traders use fundamental and technical analysis in pretty much
equal proportion, with rankings of 5 and 6. The number of FX traders mixing both
forms of analysis rises to 87% when rankings 4 and 7 are added. This underlies the
importance of technical analysis to the FX markets and the fact that most traders ignore
purist notions.
Oberlechner, however, makes little attempt to investigate the link between technical
analysis and behavioural finance, and gives little room to the idea that technical analysis
is a way of using the psychology of the markets to trade.
Above all, the book serves two purposes very well. First, as a unique survey of professional FX traders' attitudes and motives and, second, as a literature review of the various
psychological biases that impact on trading behaviour. It will therefore appeal to many
looking at the market from the outside or even those involved with hiring traders, who
may find something useful in the chapter on "Personality Psychology of Traders". For
traders themselves, however, it's a shame that Oberlechner couldn't move beyond the
squabble between psychology and economics.
March/April 2005
The Cube
The browser-based
Market Data Solution.
Real-time Data, News, Analytics,

charts and the TraderMade
database available globally 24/7,
fully customisable by you.
Contact us at:
tel: +44 (0)20 8313 0992
email: sales@tradermade.com
Commitments of Traders Report
COMMITMENTS OF TRADERS REPORT

3 February 2004 - 1 March 2005
Futures only (open interest) non-commercial net long positions and spot rates
10-year US Treasury
200000
Source: CBOT
5.00
Non-commercial net long

Spot
5-year US Treasury
Source: CBOT
300000
4.50
Spot
4.80
150000
250000
4.60
100000
4.00
200000
4.40
50000
4.20
150000
3.50
0
4.00
100000
-50000
3.80
3.00
50000
-100000
3.60
-150000
-200000
-250000
02/03/2004
3.40
3.20
02/03/2004
25/05/2004
17/08/2004
09/11/2004
01/02/2005
3.00
25/05/2004
17/08/2004
09/11/2004
Dow Jones Industrial Average
01/02/2005
-100000
Source: CBOT
15000
11000
2.00
Swiss franc
Source: CME
1.35
50000

Spot
Non commercial net-long

Spot
10800
40000
10600
30000
10400
20000
10000
1.30
5000
1.25
10200
10000
10000
1.20
9800
-10000
9600
-20000
9400
-30000
02/03/2004
-5000
1.15
-10000
02/03/2004
2.50
-50000
25/05/2004
17/08/2004
09/11/2004
Pound sterling
01/02/2005
Source: CME
2.00
45000
1.10
25/05/2004
23/11/2004
Yen
15/02/2005
Source: CME
116
50000

Spot
40000
17/08/2004
Spot
40000
114
1.95
35000
30000
112
30000
1.90
20000
25000
110
10000
20000
108
1.85
15000
0
106
10000
1.80
-10000
5000
104
-20000
1.75
-10000
02/03/2004
44
102
-30000
-5000
1.70
25/05/2004
17/08/2004
09/11/2004
01/02/2005
-40000
02/03/2004
March/April 2005
100
25/05/2004
17/08/2004
09/11/2004
01/02/2005
Commitments of Traders Report
Euro
Source: CME
10000
120
3-month eurodollar
Source: CME
600000
3.50

Spot
Spot
118
400000
3.00
200000
2.50
2.00
-200000
1.50
-400000
1.00
-600000
0.50
5000
116
0
114
-5000
112
110
-10000
108
-15000
106
-20000
02/03/2004
104
25/05/2004
17/08/2004
09/11/2004
Nasdaq
01/02/2005
Source: CME
15000
2400
-800000
02/03/2004
0.00
25/05/2004
17/08/2004
09/11/2004
Nikkei
01/02/2005
Source: CME
10000
12500
Spot

Spot
10000
2200
8000
12000
5000
6000
2000
4000
11500
1800
-5000
2000
1600
11000
-10000
1400
-15000
-2000
10500
1200
-20000
-25000
02/03/2004
1000
25/05/2004
17/08/2004
09/11/2004
Gold
01/02/2005
Source: CEI
160000
480
Spot
-4000
-6000
02/03/2004
10000
25/05/2004
17/08/2004
09/11/2004
US dollar index
10000
01/02/2005
Source: NYCE
120

Spot
118
460
140000
440
5000
116
120000
114
420
100000
0
112
400
80000
110
380
-5000
60000
108
360
40000
340
20000
0
02/03/2004
106
-10000
104
320
300
25/05/2004
17/08/2004
09/11/2004
01/02/2005
March/April 2005
-15000
02/03/2004
102
25/05/2004
17/08/2004
09/11/2004
01/02/2005
45
Long-Term Technicals
LONG-TERM TECHNICALS
Provided by Thomas Anthonj, ABN Amro, Amsterdam
EUR-USD
USD-JPY
Stalling right around a projected Fibonacci-target for a 5th wave top

(1.3650), the market could have started a setback with a minimum
down-potential of 1.1760 (bottom of wave 4). But looking at the complex consolidation structure between April and August 2004 there is
still a good chance that the latest setback has only been a minor one
within a still intact bull-trend targeting 1.3804/1.3921 (Fib projections)
and 1.4160 (historic top). If, however, the weekly trendline support at
1.2695 is taken out then we can expect a test of the breakout area
at 1.2461, which looks to be the last resort for the bulls.
Forming almost a double bottom close to the historic 101.25 low, the
rebound is still too small to argue for a reversal of the bigger beartrend. As long as the market doesn't exceed massive resistance
between 107.03 and 108.75 we expect renewed weakness and finally a break below 101.25. Thereunder, the downside would be pretty
open towards the head-and-shoulders target at 95.75. A break above
108.75 would on the other hand call for another test of neckline
resistance at 114.78. It would require a break above the latter to
confirm a long-term up-trend.
GBP-USD
Brent Crude
Stalling right under the projected target zone for a potential 5th
wave top (1.9566-88) and breaking below the last major top at
1.8771 we could be due for a much bigger setback. But unless the
market breaks below trendline support at 1.8575 on a weekly close
we have no confirmation for a bigger setback or reversal yet.
Above, the resumption of the up-trend is still favored, but for further
confirmation the market has to clear decisive Fibonacci-resistance
at 1.9305.
There is slightly more room to the upside to at least test trend channel resistance at 54.45 and the calculated target zone for a 3rd wave
impulse at 57.19-58.64. A failure to reach any of these targets would
only be indicated once the market breaks decisively below 46.88
(38.2 % of the last advance). Such a break would most likely trigger
another correction into the area 41.36 to 37.77/00 from where another advance to new highs would be expected. Only a break below
37.00 to 35.50 would start reversing the bigger up-trend.
46
March/April 2005
Long-Term Technicals
Dow Jones
S&P 500
Exceeding the head-and-shoulders target (10860) has not put us on

the safe side yet as the market is still trading in the target zone for a
potential 5-wave cycle up between 11036 and 11400. The risk of
performing a 2nd wave setback is still fairly high so a close below
trendline support at 10227 should be taken very seriously. Such a
break could be the trigger to retrace 61.8 % or 76.4 % of the whole
advance from 7197. A straight break above 11350/400 would on the
other hand give room to extend the upside to 11750 (old top) from
where we could experience a bigger setback.
Still grinding its way up we are on the alert for the first signs of weakness. The market has reached a Fibonacci-target cluster for a potential 5th wave up at 1226/53 that could complete the accumulation
phase. But unless it closes below weekly trendline support at 1157
we have no evidence to argue for a bigger setback. A close below
trendline support would be worrying and could trigger a setback to
954/45 or to 886/77 at worst. On the other hand, to delay the permanent risk of a bigger setback (wave 2) the market would have to clear
strong resistance between 1246 and 1298.
Nasdaq
Nikkei
We clearly have to expect a bigger 2nd wave setback that could

easily erase 61.8 % or 76.4 % of the gains seen since October 02.
It would, however, still take a weekly close below trendline support
at 1924 to trigger a bigger decline towards 1522 (61.8 %) or
1387/64 (old low/76.4 %) and to then form the right shoulder of a
bigger inverted head-and-shoulders reversal pattern. Only a break
above 2328 would re-open the upside for substantial gains towards
2400/53 (Fibonacci-projections) or 2646 (38.2 %).
Having spent months in some kind of sideways consolidation, the

market looks like it wants to break out of an inverted head-andshoulders reversal pattern. This would give a target of 16800 once
the neckline is broken. We are still running a fairly high risk of missing the right shoulder however and that would then imply another
decline to 9383. A break below 11452 would break the row of higher
lows and give the first warning signal. A decisive break above 12200
would on the other hand only leave minor resistance at 12788 before
the upside is wide open.
March/April 2005
47
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The publication for trading and investment professionals

THE MORNING STAR

Support and resistance

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