Kris asked me to spend some time today explaining the way I analyse markets. I’m sure it could become quite confusing if you haven’t had much experience in analysing charts.
The fact is that the underlying principals are actually quite easy to grasp, but they have taken me many years to develop – over 20 years in fact.
The structure of price action can appear mind-bogglingly complex at times. Trying to make sense of the ups and downs is very difficult unless you have a bit of an understanding of a few underlying principles.
I’ll take you through those principles today…
Here’s How to Analyse the Share Market
The first principle of market behaviour that I look at is that false breaks occur far more often than real break outs. A lot of amateur traders spend their time trying to capture break outs and invariably get whipped out of their positions when prices don’t keep going in the desired direction.
Another principle is that traders place their stop losses outside the extremity of the current range. Other traders like to gun for these stop losses so you will end up seeing what I call a ‘widening distribution’ as prices oscillate from one edge of a range to the other, having false breaks of the range.
This lures in traders who are searching to capture breakouts and also stops out any traders who had their ‘stoppies’ placed in the most obvious spot.
Before the market is ready to start trending again you’ll often see between three to seven false breaks of either edge of the range. Obviously as the number of false breaks increase the probability that the current false break could turn into a larger move outside of the range increases.
Another important point to make is that uptrends will begin from a false break of the bottom of the range and vice versa. The best risk/reward spots to join a trend is buying false breaks of the bottom of a range in an uptrend and selling false breaks of the top of the range in a downtrend.
The final point I’ll make is that the point of control which is the middle of the initial range should be seen as a gravitational point around which the rest of the price action oscillates. It will often act as support and resistance, but when it can’t hold a move there is a very high probability that prices will continue in a straight line to the other side of the range.
I use the above principles on widening distributions and then overlay my trending indicators to build up a picture of the current state of the market.
So, What Indicators Do I Use in my Analysis?
My trending indicators are the 10, 35 and 200 day moving averages. I use an exponential 10 day and a simple 35 day and 200 day moving average.
A short term trend is defined by prices being above or below the 10 day moving average. The intermediate trend is when the 10 day moving average is above or below the 35 day moving average and the long term trend is when the 35 day moving average is above or below the 200 day moving average (I also use the 10 week/35 week moving average crossover for this purpose).
It’s the combination between all of these factors that describes the state of the market.
Now that I have outlined some of the basic principles let’s have a look at a live example and make a concrete prediction about what is coming next.
The above chart is a weekly chart of the Hang Seng, which is the Hong Kong stock market index. If you think the Hang Seng is an obscure chart to pick, it isn’t. Most of the major global indices are easy to trade if you use CFDs. That means it’s just as easy to trade the Hang Seng, the S&P500 or the FTSE 100 as it is to trade the ASX 200 index.
This chart goes back to mid-2009. The initial range which all of the calculations are made off is between about 19,400 and 23,100 and was completed by early 2010. In other words all of the price action that has taken place since then can be understood from this initial range.
The point of control sits at 21,300. (Where we are right now! More on that later.) You can see how the price action has developed over the past few years in relation to what I told you at the start of the article.
We have seen two major false breaks of either edge of the range with the reversal in both false breaks occurring about 0.618 (Fibonacci) outside of the initial range. Prices either found resistance or support at the point of control (February 2012, April 2013) but when the POC was breached we saw a quick move to the other side of the range (early 2010, mid-2011, mid-2012).
The blue line in the chart is the 10 week moving average and the red line is the 35 week moving average. As I said above I use the 10/35 week crossover as a long term trend indicator.
The long term trend has shifted to down only three times in the past four years (the black circles in the chart) and on two out of three occasions we saw a sharp decline with one of them being the beginning of a 30% fall (early 2011).
The Hang Seng is about to send the fourth long term downtrend signal and is busting down through the point of control on a weekly chart.
When you add up the principles above it seems pretty clear that there is a high risk we are about to see the Hang Seng fall all the way to the bottom of the range at 19,400. That would be a 9% fall from here. A weekly close above the 10 week moving average would negate that view in the short term.
I hope I have gone some way towards removing any confusion when I write my articles about the state of the market and where I see the opportunities. Combining my trending indicators with my theories about distributions can be a powerful way to stay in tune with the market.
But if you’re still a little unsure of how it works, don’t worry. Remember, I study charts every day, and have done for the past 20 years. It can take time to identify key patterns that appear in stock and index charts.
Murray Dawes
Editor, Slipstream Trader
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