Elliott and Gann have become household names among the worldwide trading community. These pioneers of technical analysis developed some of the most widely used techniques in the field. But how did Ralph Nelson Elliott and W.D. Gann come up with these techniques, and how did they become so successful? Truth be told, it’s not as difficult as it sounds! This article takes you through the process of building your own custom indicator, which you can use to gain an edge over the competition.

Background

Recall that the theory behind technical analysis states that financial charts take all things into account—that is, all fundamental and environmental factors. The theory goes on to state that these charts display elements of psychology that can be interpreted via technical indicators.

To better understand this, let’s look at an example. Fibonacci retracements are derived from a mathematical sequence: 1, 1, 2, 3, 5, 8, 13 and so on. We can see that the current number is the sum of the previous two numbers. What does this have to do with the markets? Well, it turns out that these retracement levels (33%, 50%, 66%) influence traders’ decisions to such an extent that the levels have become a set of psychological support and resistance levels. The idea is that, by finding these points on charts, one can predict the future directions of price movements.

Components of an Indicator

All indicators are created to predict where a price is headed when a certain condition is present. Traders try to predict two basic things:

• Support and resistance levels: These are important because they are the areas at which prices reverse direction.
• Time: This is important because you need to be able to predict when price movements will occur.

Occasionally, indicators predict these two factors directly—as is the case with Bollinger Bands or Elliott’s waves—but indicators commonly have a set of rules enacted in order to issue a prediction.

For example, when using the breadth thrust indicator (which is represented by a line indicating momentum levels), we need to know which levels are relevant. The indicator itself is simply a line. The breadth thrust indicator looks similar to RSI, in that it is “range-bound,” and it is used to gauge the momentum of price movements. When the line is in the median zone, there is little momentum. When it rises into the upper zone, we know that there is increased momentum and vice versa. One could look to take a long position when the momentum is on the rise from low levels and look to short after the momentum peaks at a high level. It is important to set rules to interpret the meaning of an indicator’s movements in order to make them useful.

With this in mind, let’s look at ways of creating predictions. There are two main types of indicators: unique indicators and hybrid indicators. Unique indicators can be developed only with core elements of chart analysis, while hybrid indicators can use a combination of core elements and existing indicators.

Components of Unique Indicators

Unique indicators are based on inherent aspects of charts and mathematical functions. Here are two of the most common components:

1. Patterns

Patterns are simply repeating price sequences apparent over the course of a given time period. Many indicators use patterns to represent probable future price movements. For example, Elliott Wave theory is based on the premise that all prices move in a certain pattern that is simplified in the following example:

There are many other simple patterns that traders use to identify areas of price movement within cycles. Some of these include triangles, wedges, and rectangles.

These types of patterns can be identified within charts simply by looking at them; however, computers offer a much faster way to accomplish this task. Computer applications and services provide the ability to locate automatically such patterns.

2. Mathematical Functions

Mathematical functions can range from price averaging to more complex functions based on volume and other measures. For example, Bollinger Bands are simply fixed percentages above and below a moving average. This mathematical function gives a clear price channel showing support and resistance levels.

Components of Hybrid Indicators

Hybrid indicators use a combination of existing indicators and can be thought of as simplistic trading systems. There are countless ways in which elements can be combined to form valid indicators. Here’s an example of the MA crossover:

This hybrid indicator utilizes several different indicators including three instances of the moving averages. One must first draw the three-, seven- and 20-day moving averages based on the price history. The rule then looks for a crossover in order to buy the security or a cross-under in order to sell. This system indicates a level at which price movement can be expected and provides a reasonable way to estimate when this will occur (as the lines draw closer together). Here’s what it might look like:

Creating an Indicator

A trader can create an indicator by following several simple steps:

1. Determine the type of indicator you wish to build: unique or hybrid.
2. Determine the components to be included in your indicator.
3. Create a set of rules (if necessary) to govern when and where price movements should be expected to occur.
4. Test your indicator in the real market through backtesting or paper trading.
5. If it produces good returns, put it into use.

An Example

Suppose we want to create an indicator that measures one of the most basic elements of the markets: price swings. The goal of our indicator is to predict future price movements based on this swing pattern.

Step 1:

We look to develop a unique indicator using two core elements, a pattern and math functions.

Step 2:

Looking at weekly charts of company XYZ’s stock, we notice some basic swings between bullishness and bearishness that each last about five days. As our indicator is to measure price swings, we should be interested in patterns to define the swing and a mathematical function, price averages, to define the scope of these swings.

Step 3:

Now we need to define the rules that govern these elements. The patterns are the easiest to define: they are simply bullish and bearish patterns that alternate every five or so days. To create an average, we take a sample of the duration of upward trends and a sample of the duration of downward trends. Our end result should be an expected time period for these moves to occur. To define the scope of the swings, we use a relatively high and a relative low, and we set these at the high and low of the weekly chart. Next, to create a projection of the current incline/decline based on past inclines/declines, we simply average the total inclines/declines and predict the same measured moves (+/-) occur in the future. The direction and duration of the move, again, is determined by the pattern.

Step 4:

We take this strategy and test it manually, or use software to plot it and create signals. We find that it can successfully return 5% per swing (every five days).

Step 5:

Finally, we go live with this concept and trade with real money.

Bottom Line

Building your own indicator involves taking a deeper look into technical analysis and then developing these basic components into something unique. Ultimately, the aim is to gain an edge over other traders. Just look at Ralph Nelson Elliott or W. D. Gann. Their successful indicators gave them not only a trading edge but also popularity and notoriety within financial circles worldwide.

Traders and analysts rely on a variety of different indicators to track volatility and to determine optimal exit or entry points for trades. While high volatility is often a deterrent for a risky trade, increased fear during extreme market moves can also create buying opportunities and provide an exceptional trading ground for experienced investors.

On the other hand, periods of low volatility—accompanied by investor complacency—can warn of frothy market conditions and potential market tops. Some of the most commonly used tools to gauge relative levels of volatility are the Cboe Volatility Index (VIX), the average true range (ATR), and Bollinger Bands®.

Cboe Volatility Index

The Cboe Volatility Index is one of the most widely watched gauges of market volatility. Updated throughout the trading day and known by its ticker symbol, VIX, the index is computed using an option-pricing model and reflects the current implied or expected volatility that is priced into a strip of short-term S&P 500 Index options.

Because large institutions account for a large portion of trading in S&P Index options, their volatility perceptions (as measured by VIX) are used by other traders to help get a reading of likely market volatility in the days ahead.

The Cboe Volatility Index stays between 12 and 35 the majority of the time, but it has also dropped into the single digits and has rallied to more than 75. Generally, VIX values higher than 30 indicate increased volatility, while values in the low teens are indicative of low volatility.

Derivatives, such as futures and options, on VIX are actively traded. In addition, leveraged exchange-traded funds based on the volatility index—like the ProShares Ultra VIX Short-Term Futures ETF (UVXY) and its partner ProShares Short VIX Short-Term Futures ETF (SVXY)—exist as well.

Average True Range

While VIX measures S&P 500 volatility, the average true range indicator, developed by J. Welles Wilder Jr., is a technical chart indicator that can be applied to any stock, exchange-traded fund, forex pair, commodity, or futures contract. ATR calculates what Wilder called “true range” and then creates the ATR as a 14-day exponential moving average (EMA) of the true range. The true range is found by using the highest value generated by one of three equations:

True range = Current day’s high minus the current day’s low
True range = Current day’s high minus the previous day’s close
True range = Previous day’s close minus the current day’s low

The ATR is then created as an EMA (computed using the highest value found when the three equations are solved). A larger ATR indicates higher trading ranges and thus increased volatility. Low readings from the ATR are generally consistent with periods of quiet or uneventful trading.

Bollinger Bands®

Bollinger Bands® is another charter indicator and consists of two lines or bands, which are two standard deviations above and below the 20-day moving average, which appears as a line in between the two bands. Widening of the bands shows increased volatility, and narrowing of the bands shows decreased volatility. Like ATR, Bollinger Bands® can be applied to any stock or commodities chart.

The Bottom Line

Market volatility goes through cycles of highs and lows. Analysts watch the direction of market movement when there is a sharp increase in volatility as a possible indication of a future market trend. While VIX is useful in seeing overall levels of volatility of the S&P 500 Index, ATR and Bollinger Bands® can be applied to stocks, commodities, forex, indexes, or futures using any number of charting applications.

Price patterns are seen in identifiable sequences of price bars shown in technical analysis charts. These patterns can be used by to examine past price movements and predict future ones for a particular trading instrument. Readers should already be familiar with trendlines, continuation price patterns and reversal price patterns.

In this article, we will explore how to interpret the patterns once they have been identified and examine the rare but powerful triple top and triple bottom patterns.

Duration

The duration of the price pattern is an important consideration when interpreting a pattern and forecasting future price movement. Price patterns can appear on any charting period, from a fast 144-tick chart, to 60-minute, daily, weekly or annual charts. The significance of a pattern, however, is often directly related to its size and depth.

Patterns that emerge over a longer period of time generally are more reliable, with larger moves resulting once price breaks out of the pattern. Therefore, a pattern that develops on a daily chart is expected to result in a larger move than the same pattern observed on an intraday chart, such as a one-minute chart. Likewise, a pattern that forms on a monthly chart is likely to lead to a more substantial price move than the same pattern on a daily chart.

Price patterns appear when investors or traders become used to buying and selling at certain levels, and therefore, price oscillates between these levels, creating patterns such as flags, pennants and the like. When price finally does break out of the price pattern, it can represent a significant change in sentiment. The longer the duration, the harder buyers will have to push to break above an area of resistance (and the harder sellers will have to push to break below an area of support), resulting in a more formidable move once price does break in either direction. Figure 1 shows a pennant price pattern that formed on the weekly chart of Alphabet Inc. (GOOG). Once price continued in its established direction, the upward move was substantial.

Volatility

Similarly, the degree to which price fluctuates within a price pattern can be useful in analyzing the validity of a price pattern, as well as in predicting the magnitude of the eventual price breakout. Volatility is a measurement of the variation of prices over time. Greater price fluctuations indicate increased volatility, a condition that can be interpreted as a more active battle between the bears, who are trying to push prices down, and the bulls, who are trying to push prices up. Patterns showing larger degrees of volatility are likely to result in more significant price moves once price breaks out of the pattern.

Larger price movements within the pattern may signify that the opposing forces—the bulls and the bears—are engaged in a serious battle, rather than a mild scuffle. The greater the volatility within the price pattern, the more anticipation builds, leading to a more significant, possibly explosive, price move as price breaches the level of support or resistance.

Volume

Volume is another consideration when interpreting price patterns. Volume signifies the number of units of a particular trading instrument that have changed hands during a specified time period. Typically, a trading instrument’s volume is displayed as a histogram, or a series of vertical lines, appearing beneath the price chart. Volume is most useful when measured relative to its recent past. Changes in the amount of buying and selling that is occurring can be compared with recent activity and analyzed: Any volume activity that diverges from the norm can suggest an upcoming change in price.

If price breaks above or below an area of resistance or support, respectively, and is accompanied by a sudden increase in investor and trader interest—represented in terms of volume—the resulting move is more likely to be significant. The increase in volume can confirm the validity of the price breakout. A breakout with no noticeable increase in volume, on the other hand, has a far greater chance of failing since there is no enthusiasm to back the move, particularly if the move is to the upside.

Guidelines for Interpreting Patterns

Three general steps help technical analysts interpret price patterns:

1. Identify: The first step in successfully interpreting price patterns is to identify valid patterns in real time. The patterns are often easy to find on historical data but can become more challenging to pick out while they are forming. Traders and investors can practice identifying patterns on historical data, paying close attention to the method that is used for drawing trendlines. Trendlines can be constructed using highs and lows, closing prices or another data point in each price bar.
2. Evaluate: Once a pattern is identified, it can be evaluated. Traders and investors can consider the duration of the pattern, accompanying volume and the volatility of the price swings within the price pattern. Evaluating these can give a better picture regarding the validity of the price pattern.
3. Forecast: Once the pattern has been identified and evaluated, traders and investors can use the information to form a prediction, or to forecast future price movements. Naturally, price patterns do not always cooperate, and identifying one does not guarantee that any particular price action will occur. Market participants, however, can be on the lookout for activity that is likely to occur, enabling them to respond quickly to changing market conditions.

Triple Tops and Bottoms

Triple tops and bottoms are extensions of double tops and bottoms. If the double tops and bottoms resemble an “M” or “W,” the triple tops and bottoms bear a resemblance to the cursive “M” or “W”: three pushes up (in a triple top) or three pushes down (for a triple bottom). These price patterns represent multiple failed attempts to break through an area of support or resistance. In a triple top, price makes three tries to break above an established area of resistance, fails and recedes. A triple bottom, in contrast, occurs when price makes three stabs at breaking through a support level, fails and bounces back up.

A triple top formation is a bearish pattern since the pattern interrupts an uptrend and results in a trend change to the downside. Its formation is as follows:

• Prices move higher and higher and eventually hit a level of resistance, falling back to an area of support.
• Price tries again to test the resistance levels, fails and returns toward the support level.
• Price tries once more, unsuccessfully, to break through resistance, falls back and through the support level.

This price action represents a duel between buyers and sellers; the buyers try to lift prices higher, while the sellers try to push prices lower. Each test of resistance is typically accompanied by decreasing volume, until price falls through the support level with increased participation and corresponding volume. When three attempts to break through an established level of resistance have failed, the buyers generally become exhausted, the sellers take over and price falls, resulting in a trend change.

Triple bottoms, on the other hand, are bullish in nature because the pattern interrupts a downtrend and results in a trend change to the upside. The triple bottom price pattern is characterized by three unsuccessful attempts to push price through an area of support. Each successive attempt is typically accompanied by declining volume, until price finally makes its last attempt to push down, fails and returns to go through a resistance level. Like triple tops, this pattern is indicative of a struggle between buyers and sellers. In this case, it is the sellers who become exhausted, giving way to the buyers to reverse the prevailing trend and become victorious with an uptrend. Figure 2 shows a triple bottom that once developed on a daily chart of McGraw Hill shares.

A triple top or bottom signifies that an established trend is weakening and that the other side is gaining strength. Both represent a shift in pressure: With a triple top, there is a shift from buyers to sellers; a triple bottom indicates a shift from sellers to buyers. These patterns provide a visual representation of the changing of the guard, so to speak, when power switches hands.

Bottom Line

Price patterns occur on any charting period, whether on fast tick charts used by scalpers or yearly charts used by investors. Each pattern represents a struggle between buyers and sellers, resulting in the continuation of a prevailing trend or the reversal of the trend, depending on the outcome. Technical analysts can use price patterns to help evaluate past and current market activity, and forecast future price action in order to make trading and investing decisions.