How to Use Channalyze

NOTE: this guide will be updated every few weeks and a list of securities in various markets which are considered to be currently predictable will be appended at the end. Channels and Cycles the basics
Channels Channels are based on the calculation of centered moving averages. Averages are employed in order to smooth the data so that trends become more obvious. An average of a specific period will remove most of the short term movements caused by cycles of shorter wavelength than the period used for that average. In Channalyze, the average is usually triangularly weighted since this is superior to a simple average for the removal of the short term cycles. Thus the plotted average is the result of the combination of all cycles with wavelength greater than the span chosen for the average. This is a very important point which must be understood clearly. By the nature of its calculation, a centered average when plotted terminates at the center point of the span. In order that the centre point corresponds to the position of a data point, and not in between two points, odd-numbered spans are used for channels and indeed for cycles. Thus a channel based on a particular value N for its period (span) will terminate at a point (N-1)/2 back in time.

Channel boundaries are constructed with the lower boundary a certain value below that of the centered average, and the upper boundary this same value above that of the centered average. The important fact is that because of this method of plotting channels, they are of constant depth throughout their development over time. The boundaries, and hence of course the depth, are adjusted so that a limited number of points of the underlying data lie outside the boundaries. The default value is to allow 3.5% of the points to lie outside of the boundaries. The channel depth can 1

be altered within Channalyze so that more or fewer points can be contained within the channel. The theory behind the use of channels is that once the security value approached a boundary, it will reverse the direction of movement and travel back to the centre of the channel. These various features can be seen in the chart of a 101-point channel for Agilent Technology. The boundaries based on a 101 point triangular average are shown in blue.

From what has been discussed so far, it is obvious that the path of the channel over the section from the last true calculated point ((N-1)/2 points, i.e. 50 points in the past) is not known but has to be estimated. This missing portion is known as the gap In Channalyze it is usual to plot this extrapolated portion of the channel (gap) in a different color from that used for the plot of the true calculated channel. This then draws attention to the fact that the gap has to be filled in by an estimate. In order to emphasize the change from the true calculated values (plotted in blue) to the extrapolated values (plotted in red) a black vertical line is drawn. The extrapolated red boundaries across the gap are computed by a curve fitting routine based on the most recent portion of the true channel. Since this can be seen to be flattening out, the extrapolated red portion is also fairly flat. Often this computer extrapolation of the channel will seem to run counter to the perceived movement of the data. In such cases the user can produce his/her own channel superior extrapolation by using the bending routine to accommodate the data movement (access this from Chans/Cycles then Adjust Channel). Since the channel boundaries are drawn so as to contain 96.5% of the data points (in the default case) it is not surprising that as the price movement approaches a boundary, it reverses direction. Since a small number (3.5% in this case) of points are allowed to lie outside of the channel, then obviously there will be some places where the price movement penetrates the channel boundary to a limited extent. Thus a channel boundary represents a position of high probability for a price reversal.

The current position of the channel is only an estimate!

If we know the position of the channel right up to the present time then we will be 96.5% correct in predicting the price movement since it will oscillate within the channel. However, it is important to realise that the extrapolation of channel boundaries leads to an estimate of the current position of the channel. Successful use of channel analysis therefore depends upon reducing as far as possible the error associated with estimating the path of the channel over the gap. As with all estimates, this is subject to error, but manual bending will reduce this error if due notice is taken of the minor peaks and troughs in the data and the boundaries are moved so as to minimize any penetration by such minor peaks and troughs. In the case of Agilent, the trader would wait for the price fall to take it down to the lower boundary as drawn in red. At that point, attention would turn to whether or not the price falls below the current lower boundary or bounces back. If the price reverses direction then that is good evidence that the estimated position of the boundary is more or less correct, and a decent price rise can be expected. If it does not bounce back then the boundary has to be adjusted downwards, and continue to be adjusted downwards while the price continues to fall. Under such

circumstances no decision should be taken about future price movement until a price reversal helps to establish the new lower boundary. Great care has to be taken if bending the channel so as to cause a change in direction within the extrapolated portion. In such a case an examination of cycle sums can provide more confidence that the channel has actually changed direction. Since the price is oscillating within the channel, knowledge that a change in direction has occurred is of prime importance for the trader. Channalyze allows the price data to be cut off in the past, so that the user can practice manual extrapolation of the channels and compare this with the computer extrapolations. The results can then be checked against the subsequent price movement of the security. By this means a great improvement can be made in the predictability of the current and near future movement of the channel and thus of the future price movement. Cycles Just as the current position of a channel can only be estimated, so is the current position of a cycle only an estimate. The last true position of a cycle occurs at a point in the past which is plotted more than half of the period used for the cycle back from the present time. Thus the greater the wavelength of the cycle which is being determined, the further back is the last true position. As is the case with channels, some mathematics has to be applied to determine how the cycle has probably moved up to the present time and how it is likely to move in the near future.

As with channels, it is accepted practice to use a different color for the plot of the extrapolated potion of the cycle. The chart of Agilent Technology is shown with a cycle of wavelength 101 days plotted in the box below the price movement. The vertical black line shows the last true calculated point for the cycle (plotted in blue) and the vertical blue line represents the point in time of the most recent price point. The red portion of the cycle plot is the estimate of how it has moved from the last true point. In all plots of cycles the estimate is a sine wave whose wavelength has been calculated from the recent section of the true cycle. 3

This is only one of a number of cycles which are present in the data which can be plotted by using different values for the cycle periods.

Comparing like with like

The trader should not jump to the conclusion that because the extrapolated portion of this cycle is showing a rise from the present time that therefore the picture given by the channel shown previously for a bounce up from the channel boundary is correct. This is because, as stressed in the first paragraph of this article that a channel is depicting the sum of all cycles with wavelength greater than the span chosen for the average. In contrast, the cycle plot shown above is the behaviour of a narrow band of cycles whose central value is the period chosen for the cycle plot. Thus to marry up the message being given by channels with that given by cycles it is necessary to view the sum of cycles greater than a certain value and compare that with the channel produced when the same value is used for the period (span) of the channel. This will be examined shortly, but first it is necessary to discuss the meaning of cycles in market data.

Cycles in market data

A regular cycle is a sine wave has three characteristics:1. Wavelength. This is the distance from peak to peak or trough to trough and is constant. 2. Amplitude. This is the vertical height from the level of the troughs to the level of the peaks. 3. Phase. This is how far from some arbitrary point the wave is. If two waves of the same wavelength and amplitude are out of phase, then their peaks and troughs will not coincide but are offset from each other.

The sine wave shown above has amplitude of 50 and wavelength of 101. The important point is that it is regular and predictable. We know how this wave will proceed into the future. Cycles in the stock market are not regular for more than a few sweeps, i.e. a few wavelength values. They vary constantly in phase and amplitude. Although they might vary in wavelength, it is more useful to take the view that an apparent change in wavelength, i.e. a change in the peak to peak or trough to trough distance from distance between the previous peaks or troughs is actually the result of a change in phase which gives the same result. This failure to recognize the constant variation is what has led to poor results in the past when cycle analysis has been applied to the stock market. The variation which occurs in market data is shown for the 101-point cycle in Boston Scientific.

It can be seen quite clearly that the cycle changes drastically in amplitude and phase. This example has been chosen because of the wide variation, but even so the crucial aspect of the way in which Channalyze uses market cycles can be seen in the rectangular box. This is the fact that for a time span of around three wavelengths the cycles pass through a period of time when they are regular in phase and amplitude, i.e. the apparent wavelength is fairly constant. Channalyze is able to determine whether the most recent history of the particular cycle shows the cycle to be stable and hence predictable into the near future. Only these stable cycles will be used in determining the future behaviour of the cycle sum. The greater the wavelength of the cycle which is currently stable, then the further into the future its behaviour can be predicted. Channalyze allows the user to view the sum of all stable cycles within the wavelength range which has been selected. This is normally from 7 to 350 days. The sum can be displayed in the lower box or superimposed on the plot of the security. The extrapolated part of the cycle sum should be plotted in another color, just as was the case with channels and single cycles. This then shows quite clearly from which point in the past the cycle sum has been extrapolated, and underlines the fact that the last true cycle some is some way in the past.

Since the cycle sum has been extrapolated from some point in the past, then this fact can be used to see how accurate the extrapolated section has been as a predictor of price movement up to the present time. The best way of comparing the predicted cycle sum with the price movement is to use a short term centered average such as a 9 point average. This will remove the day to day fluctuations and enable a rapid comparison to be made. If the cycle sum does not mirror fairly closely this 9-point average over the period of extrapolation, then the future price cannot be predicted and attention should shift to another security. This fact cannot be stressed to highly it is vital to follow this rule if success is to be achieved. Now we have the theoretical basis of Channalyze, then we can look at a few examples to show when to predict and when not to predict into the future. The following steps should be followed: 1. Via the Calculations menu, set up a 9-point centered average in a color different from that which will be used for the cycle sums. Choose a medium line thickness for clarity in viewing the resulting plot. 2. Via the Calculations menu, select Cycle Sums and choose say blue and red as the colors. Choose medium line thickness for clarity in comparing the cycle sum with the 9-point centered average. 3. Now set up Chans/Cycles Autoscan to scan all the securities in the current folder and click on OK, Scan. 4. Leave Channalyze scanning the current folder. Once the scan is complete, click on Chans/Cycles then click on Show Cycle Sums. You can then move down the security list and examine each plot in turn by clicking on the button with the right pointing arrow. You will find that 90% of the securities show no real correlation between the extrapolated cycle sum and the 9 point centered average. Such an example is shown for American Express. Quite clearly there is a divergence from point 1450 onwards between the 9-point average and the cycle sum. The advantage of this average is that it is true up to four points back in time from the latest data point, and acts as a significant measure of correlation. Pass swiftly on to the next security in all cases like this. In times of severe market turbulence, they will only be a very few securities in which the cycles have remained stable enough for a good prediction of future price movement to be made.

However, once you have found a handful of securities which are predictable, then you can concentrate on these for the next few weeks. The total scanning exercise needs to be carried out only every few weeks since the appearance of stable cycles will take this amount of time. An example of a security which does appear to be predictable because of the close correlation between the extrapolated cycle sum and the 9-point average is Excel Energy Inc.

It can be seen that the red extrapolated portion of the cycle sum begins at the beginning of 2008, and the shape of this extrapolation follows very closely that of the 9-point average (dark green) which terminates only 4 point back from the present time. Thus the prediction of a rise from this point onwards has to be taken as being highly accurate.

Some more information can now be gathered by clicking on the Show Cycle Distribution for each Plot. This is the type of distribution we need to see where there are only a few groups of cycles.

We can use the Med-Hi Divide and Lo-Med Divide to adjust the boundaries so that the group of wavelengths between 75 and 100 can be summed separately. By clicking on Sum Green these medium wavelength cycles are plotted as a sum, as shown in the next chart.

Clearly we can see that it is the sum of these cycles which will be driving the price upwards over the next few weeks. An example of a security which has given an excellent correlation since July 2007 is shown for the Hercules Corporation. This predicts that the price will level off and oscillate within a narrow band for a few weeks.

These few examples should serve to show how Channalyze should be used. It must be stressed that the correlation can break down suddenly at any time, and so it is important that if a trading position is taken, the cycle sum is then monitored daily from that point onwards. In addition a stop loss should be used. List of Securities with Stable Cycles Produced 24th November 2008 From the SP500 folder Abbot Laboratories, Aon, Baker-Hughes, Campbell Soup, Chevron Texaco, Consolidated Edison, Devon Energy Corp, Fedex, General Mills, Hercules Incorporated, Key Corp, Kimberley Clark, Kroger, McDonalds, Occidental, PG & E Corporation, Progress Energy, Raytheon, Rowan Companies, Sempra Energy, Southern Company, Vulcan Materials, Xcel Energy. From the FTSE100 Folder Astrazeneca, Autonomy, Bae Systems, British American Tobacco, Cable and Wireless, Lloyds TSB, Wm Morison, Pearson, Standard Life, Wolseley. From the Toronto Folder Agnico-Eagle Mines, Ballard Power Systems, Canadian Utilities, Eldorado Gold, Enbridge, EnCana Corp, Fronteer Dev Corp, Inter Pipeline Fund, InterOil Corp, Northbridge Financial, Northland Power Income Fund, Power Corp of Canada, Rogers Communications, Royal bank of Canada, Telus, TriStar Oil and Gas. From the Forex Folder British pound/Canadian dollar, New Zealand dollar/UK pound.