Volatility and Charting

The past week has been filled with one heart-stopping development after another. It reads somewhat like a Hollywood movie trailer ... banks fall, markets surge, bailouts abound.


People aren't exactly trading rationally right now -- evident in the large session to session index swings. Fear and uncertainty are driving the markets. So, are charts reliable in these volatile times?

The answer to this is very simply, yes. Chart analysis is reliable, and provides effective trading and investment solutions, basically when to enter and when to exit trades in a tight timeframe.

Charting provides three important advantages.

First, it objectively records the market's view and opinion of a stock created by those who buy and sell. Opinions backed by money are the key factors here. The collapse of Lehman Brothers and AIG is not a surprise.

Their charts have shown a steady, prolonged, severe downtrend for the past nine months. The contradiction between company announcements --we do not have a problem -- and the chart trend which showed significant problems, highlights the objectivity. The charts told the real story that was only later revealed.

The second advantage, is the way charts capture the psychological behavior of investors and traders. This can be directly observed on a chart -- its support and resistance levels, and trending behavior. When markets fall, they pause at previous support levels. When markets rebound, the rally is capped at previous resistance levels. These levels are created by the aggregate behavior of individual investors.

These psychological behavioral reactions are further analyzed using technical analysis methods designed to isolate psychological behavioral patterns.

We use the Guppy Multiple Moving Averages (GMMA) analysis to understand investor and trader thinking. A small number of chart patterns highlight the behavior probability of market participants. These include the head and shoulder pattern seen on the Dow. (GMMA analysis is different from some technical analysis methods which try to use the statistical behavior of the market to identify turning points in advance)

The third chart advantage, is the analysis of short-term price movements to understand the limitations and behavior of price volatility. In the current situation, we use a GMMA Trend Volatility Line analysis to improve entry and exit conditions for intraday and short-term trading. This targets momentum, highlighting significant price moves.

Australia's S&P/ASX 200 Index chart shows how these factors are combined to develop a successful short trade executed last week. After the Dow's plunge on Tuesday, (16 Sept.) it was pretty obvious that there would be a panic fall in the Australian market Wednesday.

guppy volatility.jpg

Analysis of the daily chart suggested support was near 4,700 along the value of the neckline line in the head and shoulder pattern. A rebound from here has a target near 5,000. This retreat and rally takes place in the context of a downtrend created by a long-term head and shoulder pattern.

Traders expect a strong psychological reaction. One-minute charts are used to identify the point where selling pressure overwhelms buyers. The GMMA applied to the one minute chart shows this. The long term group – red lines – compress and turn down. Sellers control the trend. Traders – blue lines – do not have the buying strength to fight the trend.

The volatility of the trend is tracked using the trend volatility line (pink line). It defines the amplitude and duration of the changes in intraday volatility. It tells the trader when to get out of the trade. This derivative trade delivers good profits because the chart analysis captures the behavior in several different time frames.

The market is founded on fundamentals, but price discovery and trending behavior is primarily set by the emotions and behavior of participants. This is emotional behavior that is reflected in a rational decision making process. Buying and selling is almost always a rational decision but it is filtered through a prism of emotion.

The degree of emotion, aggregated in trading activity, defines the nature and character of the trend and this is most effectively understood when using chart analysis.

If you would like Daryl to chart a specific stock, commodity or currency, please write to us at ChartingAsia@cnbc.com. We welcome all questions, comments and requests.

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