TheTechnicalTake.com - Price Structure Analysis

7/23/2008

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Trend Analysis

Price Structure Analysis� is a proprietary indicator that tracks the price action. There are no other factors such as monetary conditions or breadth factors involved in its calculation. This is pure price action, and it is an attempt to quantify and qualify the trend.

The development of the Price Structure Analysis indicator took several years. However, the crystallizing moment was the bottom in stock prices that occurred in March, 2003. At this time, the stock market had an explosive move and became overbought very quickly. The market stayed overbought for a very long time. If you used traditional oscillators that gave you overbought or oversold readings, you probably sat on the sidelines for a long time missing a significant portion of the move. To myself, I thought there had to be a better way, and I believe the Price Structure Analysis� indicator is a better way.

Before getting to the construction of the indicator and how it compares to other methods of following the trend, let me explain why I think this is better. First, the Price Structure Analysis� indicator does not use overbought and oversold conditions. The price action is viewed as a series of thrusts, pullbacks and pivots. If the market is strong or weak, the indicator will capture this action; if the market is intermediate, it will give you a neutral reading. In this way, all the Price Structure Analysis� indicator does is monitor the price action. As you will see, this indicator is no holy grail, but it is better than moving averages, and it could function as a low risk, high reward system in its own right.

Several words regarding semantics�. Price Structure Analysis� is the method or concept of using significant pivots and thrusts to quantify the price action. The Price Structure Analysis� indicator is the final indicator that appears on the graph and will give you the trend direction.

How is the Price Structure Analysis� indicator constructed? An indicator called a Keltner channel is placed over the price bars, and price bars are smoothed with a 5 bar moving average. Keltner channels measure volatility in the price action, and if the price action is strong, price will move outside the upper and lower volatility band of the Keltner Channels. This kind of action should get our attention. For the purposes of constructing the Price Structure Analysis� indicator, the 5 bar moving average of price must trade outside the upper or lower Keltner band, and when it does, this is considered a significant thrust. If prices are moving upward, this up thrust will eventually pullback and a pivot point is formed. (A high pivot point is formed with lows on either side of it). This pivot point, which has traded outside the Keltner channel, is considered a significant pivot point. Significant pivot points are indicative of strong price action. After a downtrend, a significant up thrust and pivot point may indicate a reversal in the trend. A close above this significant pivot point indicates that the trend has changed, and it is now upward. Conversely, after an uptrend, a significant thrust downward through the Keltner channel suggests weakening of the trend. A close below this downward significant thrust or pivot point means that the trend has changed to being down.

FIGURE 1

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Let�s review the chart in Figure #1 to get a visual handle on how this concept works. This is a daily chart of the NASDAQ composite with point 1 being the January, 2002 high and point 2 being the March, 2003 low. The Keltner Channels are the parallel blue lines, and the thick oscillating blue is the 5 bar smoothing of the price action. The parallel red dots are significant up thrusts in that the 5 bar moving average of price has thrust outside the upper Keltner channel band; the parallel black dots represent significant down thrusts.

The market moved almost 50% higher from September, 2001 to January, 2002. The first sign of trouble was the significant down thrust at point 3; note the violation of the lower Keltner channel line by the 5 day moving average of price as indicated by the black dots. Price briefly rebounded, but once price closed below the significant down thrust at point 3, the down trend was in place. So it is the closure above or below a significant up or down thrust, respectively, that solidifies a change in the trend direction. Although points 4 and 5 are significant up thrusts they were not surpassed, so the trend is still down.

The first significant up thrust or pivot point that was exceeded following the long down trend was at point 6. While this did not lead to an immediate change in the trend, this juncture was important as it was the first significant up thrust to be exceeded in 11 months. The subsequent sell off did not exceed the prior low (point 7), and this was how the eventual bottom was made in March, 2003.

So this is how the Price Structure Analysis� indicator is used to determine trend direction. The price action is seen as a series of pivots and thrusts that are either exceeded (trend continuation or trend reversal) or are tested before the trend is continued. The point of the Price Structure Analysis� indicator is to keep you in sync with the price action.

The significant pivots are computed on each price chart and their relationship to each other then determines the trend. One other factor is used in the construction of the Price Structure Analysis� indicator and that is a relative strength indicator is combined with the analysis of pivots and thrusts. This has the effect of balancing the price action especially when false moves above or below a significant pivot may occur or when the action is particularly sharp and �V� like.

How well does the Price Structure Analysis� indicator do in keeping one in sync with the trend? Looking at the NASDAQ and how the Price Structure Analysis indicator performed on the long side and short side is presented in Table 1. For long trades, a stop loss of 7% was utilized; on the short side a 5% stop loss produced the best results.

Table 1.

Price Structure Analysis			50 day Moving Average
Mode	Long	Short	Long	Short
Index	NASDAQ	NASDAQ	NASDAQ	NASDAQ
Time Period Studied	32 years	32 years	33.3 years	33.3 years
% of Time in Market	48%	21%	61%	39%
# of Trades	65	55	207	209
% Profitable	55%	38%	35%	25%
Annual Rate of Return	13.1%	41%	8.1%	9%
Return on Account	573%	852%	392%	203%
Buy and Hold Return	1330%	1320%	1580%	1603%
Select Profit Factor	2.35	3.0	2.48	1.55
Average Win::Loss	2.39	6.57	5.0	5.2
Rina Index	98	153	259	89
Stop Loss	7%	5%	4%	3%

On the long side, the Price Structure Analysis� indicator does a nice job of capturing the major trends with minimal risk to one�s trading capital. On the short side, while the number of winning trades is not all that spectacular the relatively small stop loss keeps draw downs to a minimum. This system was essentially flat for much of the bull market, and it traded very profitably from 2000 onward capturing a majority of the down trend. Or put another way, this indicator was bearish for greater than 90% of the time from September, 2000 to March, 2003. Three factors probably account for the performance differences in this indicator on the long and short side and these are 1) the bull market from 1981 to 2000; 2) the upward bias to stock prices; 3) the nature in which stock prices fall (fear and sell off) versus the manner in which they rise (wall of worry and persistency).

How well does the Price Structure Analysis� indicator compare with other trend following tools such as buying and selling the market when prices close above and below the 50 day moving average, respectively? The results of a long and short trading system using the 50 day moving average are shown in Table 1. Price Structure Analysis� performed better in almost all measures of trading system performance.

One caveat: Price Structure Analysis� is no holy grail, but what it does is interpret the thrusts and pullbacks in the price action and keeps one in sync with the trend. Within the context of a favorable investing environment, Price Structure Analysis� can make entry and exit strategies more efficient.

Support and Resistance

Using the concept of Price Structure Analysis�, key levels of support and resistance are easily identified.

FIGURE 2

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As can be seen in figure 2, significant up thrusts (parallel red dots) or down thrusts (parallel block dots) serve as important areas or zones of support and resistance. Up thrusts initially act as resistance (point 1), but as prices close above this level, it will then act as support (point 2). Similarly, down thrusts will initially act as support, but will also serve as resistance once price closes below these levels (point3). Point 4 is a significant down thrust that served as resistance for over a year. It stopped the up thrust at point 1, but once this area was cleared, it led to the mini bull market of 2003. Utilizing Price Structure Analysis� to determine support and resistance works on both daily and weekly charts.

Key trading levels on both the S&P 500 and NASDAQ markets are updated daily on the sight, and depending upon the investing back drop, these make for ideal entry and exit points.

Trendlines

Price Structure Analysis� can also be used to construct trend lines by connecting significant points together. Closes above a sloping trend line form the basis for the Price Structure Analysis� Trend Line Break Trading Systems on both the NASDAQ and S&P 500. Once the slope between two points is calculated, I am able to program the computer to look for all similar past occurrences, and this kind of price action in the past has led to some very strong returns.

Summary

Price Structure Analysis�, as a concept, is a useful tool. It can define the trend, identify support and resistance, and be used to construct trend lines. The Price Structure Analysis� indicator can be used as a sole trading system or it can be used as part of a trading system to improve entry and exit efficiency.