QQQQ Analysis Avoids Multicolinearity

09/02/10 08:39:39 AM

by Alan R. Northam

Multicolinearity is the use of several indicators all presenting the same information. The danger of multicolinearity is an analysis of a security or market based upon limited information. Here, several indicators are carefully chosen to avoid multicolinearity, resulting in an examination based upon a broad array of information.

Security: QQQQ
Position: N/A

One of the fundamental guidelines in technical analysis is to avoid multicolinearity, which is the multiple use of the same information in the analysis of a security or market. An example of multicolinearity would be to use several trend indicators in performing a technical analysis, such as moving averages, moving average convergence/divergence (MACD), and directional movement all at the same time. Instead of adding new information to the analysis, multicolinearity simply shows the same information over and over again, with the only real difference being the way in which the information is displayed.

To perform a proper technical analysis, indicators from various indicator groups should be used. These various indicator groups include trend indicators, momentum indicators, volatility indicators, and volume indicators. An example of a technical analysis would be to use one indicator from two or three of these groups. Of course, an indicator from each of the four indicator groups could be used as well. By using indicators from these various indicator groups, additional information about the security or market can be added and a more complete technical analysis is the result.

In some of my recent articles -- "Momentum Indicator Measures Trend" (published 6/29/10), "Momentum Indicator Measures Momentum" (published 7/07/10), and "Adding Volume To The Analysis" (published 8/17/10), I showed how the momentum indicator could be used to measure both trend and momentum, and how volume influences the technical analysis. In Figure 1 I have combined a trend indicator, a momentum indicator, and a volume indicator in the following technical analysis, thus avoiding the problem of multicolinearity.

FIGURE 1: QQQQ, DAILY. This chart shows the rate of change indicator in the top panel, daily price bars in the middle, and volume in the lower panel.

Graphic provided by: MetaStock.

The middle panel of Figure 1 is that of the daily price bars of the PowerShares QQQ Trust (QQQQ) exchange traded fund (ETF). This figure shows the formation of a descending triangle. According to Thomas N. Bulkowski's Encyclopedia Of Chart Patterns, descending triangles are formed by a descending trendline and a horizontal base or support line. During the formation of the descending triangle, price moves upward in shorter-term trends and then falls back down before having a chance to make a new higher high. Thus, lower and lower highs are made that can be shown with a downsloping trendline. After failing to make a new higher high, price then turns down until it finds support from a previous low. Volume normally retreats during the formation of the descending triangle.

Finally, price normally breaks out to the downside on high or low volume, but volume is usually high. Thus, the descending triangle indicates that the overall trend of QQQQ heading down.

The bottom panel of Figure 1 shows daily volume. Volume measures trader psychology about the direction of price movement. When traders are excited about the direction of price movement, they start to participate and volume increases. When traders are not excited about the direction in which price is moving, they stand aside and volume decreases.

Normally, daily volume is shown as individual vertical bars with each respective bar height representing total volume for that day. However, by displaying volume in this form it is difficult to see the overall trend of volume. Therefore, I have shown volume as a line chart instead of a bar chart. By looking at the line chart, it becomes easier to identify the peaks and troughs of volume, and thus, the overall trend. From the line chart, we can see that volume has been forming lower highs and lower lows, corresponding to the peaks and troughs. These lower highs and lower lows thus identify the volume trend as heading downward. The analysis of volume therefore agrees with the overall concept that volume retreats during the formation of a descending triangle.

Note also that from early August, volume has formed a higher low trough, a higher high peak followed by a second higher low trough. The first higher low trough and higher high peak signal that volume has reversed its trend from down to up. This change of trend informs us that volume is starting to increase. Since volume normally increases in a trending market, this increase in volume is suggesting that QQQQ is now starting to trend downward. Therefore, we should be looking for a breakdown below the descending triangle's support shelf to occur. A surprise would be for price to break out above the downsloping trendline of the descending triangle.

The rate of change indicator (ROC) is used in our analysis to measure momentum. Note that ROC has formed a head & shoulders pattern. Head & shoulders patterns normally form at the end of a trend. This then tells us that the uptrend of ROC from mid-May is now ending. A clean break down below the neckline will complete the topping process and signal that price is starting to accelerate in the downward direction.

In conclusion, note how the indicators in this analysis were chosen to avoid the problem of multicolinearity. Price patterns, which use daily high and low prices, were chosen to determine the trend; the ROC, which uses closing prices, was chosen to measure price momentum, and volume was chosen to measure trader psychology. In our analysis, we note that the stage is set for QQQQ to start heading down. Price has started to trend down from early August. Volume is starting to increase, validating the downward movement in price as a trend and not simply a corrective selloff.

Finally, momentum is set to start moving lower, indicating that price is ready to start accelerating downward. All we need now to confirm that QQQQ is headed lower is for ROC to complete its head & shoulders formation and for price to break down below the descending triangle support shelf.

Alan R. Northam

Alan Northam lives in the Dallas, Texas area and as an electronic engineer gave him an analytical mind from which he has developed a thorough knowledge of stock market technical analysis. His abilities to analyze the future direction of the stock market has allowed him to successfully trade of his own portfolio over the last 30 years. Mr. Northam is now retired and trading the stock market full time. You can reach him at inquiry@tradersclassroom.com or by visiting his website at http://www.tradersclassroom.com. You can also follow him on Twitter @TradersClassrm.

	Garland, Tx
Website:	www.tradersclassroom.com
E-mail address:	inquiry@tradersclassroom.com

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TECHNICAL ANALYSIS

QQQQ Analysis Avoids Multicolinearity

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