Introduction: Price Patterns

INTRODUCTION

So far we've touched on Dow Theory, which is the basis of most trend following work being used today. We've examined the basic concepts of trend, such as support, resistance, and trendlines. And we've introduced volume and open interest. We're now ready to take the next step, which is a study of chart patterns. You'll quick­ly see that these patterns build on the previous concepts.

In Chapter 4, the definition of a trend was given as a series of ascending or descending peaks and troughs. As long as they were ascending, the trend was up; if they were descending, the trend was down. It was stressed, however, that markets also move sideways for a certain portion of the time. It is these periods of sideways market movement that will concern us most in these next two chapters.

It would be a mistake to assume that most changes in trend are very abrupt affairs. The fact is that important changes in trend usually require a period of transition. The problem is that these periods of transition do not always signal a trend reversal. Sometimes these sideways periods just indicate a pause or consol­idation in the existing trend after which the original trend is resumed.

PRICE PATTERNS

The study of these transition periods and their forecasting impli­cations leads us to the question of price patterns. First of all, what are price patterns? Price patterns are pictures or formations, which appear on price charts of stocks or commodities, that can be clas­sified into different categories, and that have predictive value.

TWO TYPES OF PATTERNS: REVERSAL AND CONTINUATION

There are two major categories of price patterns—reversal and continuation. As these names imply, reversal patterns indicate that an important reversal in trend is taking place. The continua­tion patterns, on the other hand, suggest that the market is only pausing for awhile, possibly to correct a near term overbought or oversold condition, after which the existing trend will be resumed. The trick is to distinguish between the two types of pat­terns as early as possible during the formation of the pattern.

In this chapter, we'll be examining the five most com­monly used major reversal patterns: the head and shoulders, triple tops and bottoms, double tops and bottoms, spike (or V) tops and bottoms, and the rounding (or saucer) pattern. We will examine the price formation itself, how it is formed on the chart, and how it can be identified. We will then look at the other important con­siderations—the accompanying volume pattern and measuring implications.

Volume plays an important confirming role in all of these price patterns. In times of doubt (and there are lots of those), a study of the volume pattern accompanying the price data can be the deciding factor as to whether or not the pattern can be trusted.

Most price patterns also have certain measuring techniques that help the analyst to determine minimum price objectives. While these objectives are only an approximation of the size of the subsequent move, they are helpful in assisting the trader to determine his or her reward to risk ratio.

In Chapter 5, we'll look at a second category of patterns— the continuation variety. There we will examine triangles, flags, pennants, wedges, and rectangles. These patterns usually reflect pauses in the existing trend rather than trend reversals, and are usually classified as intermediate and minor as opposed to major.

Preliminary Points Common to All Reversal Patterns

Before beginning our discussion of the individual major reversal patterns, there are a few preliminary points to be considered that are common to all of these reversal patterns.

1. A prerequisite for any reversal pattern is the existence of a prior trend.
2. The first signal of an impending trend reversal is often the breaking of an important trendline.
3. The larger the pattern, the greater the subsequent move.
4. Topping patterns are usually shorter in duration and more volatile than bottoms.
5. Bottoms usually have smaller price ranges and take longer to build.
6. Volume is usually more important on the upside.
7. The Need for a Prior Trend.

The existence of a prior major trend is an important prerequisite for any reversal pattern. A market must obviously have something to reverse. A formation occasionally appears on the charts, resembling one of the reversal patterns. If that pattern, however, has not been preceded by a trend, there is nothing to reverse and the pattern is suspect. Knowing where cer­tain patterns are most apt to occur in the trend structure is one of the key elements in pattern recognition.

A corollary to this point of having a prior trend to reverse is the matter of measuring implications. It was stated earlier that most of the measuring techniques give only minimum price objec­tives. The maximum objective would be the total extent of the prior move. If a major bull market has occurred and a major top­ping pattern is being formed, the maximum implication for the potential move to the downside would be a 100% retracement of the bull market, or the point at which it all began.

The Breaking of Important Trendlines. The first sign of an impend­ing trend reversal is often the breaking of an important trendline. Remember, however, that the violation of a major trendline does not necessarily signal a trend reversal. What is being signaled is a change in trend. The breaking of a major up trendline might sig­nal the beginning of a sideways price pattern, which later would be identified as either the reversal or consolidation type. Sometimes the breaking of the major trendline coincides with the completion of the price pattern.

The Larger the Pattern, the Greater the Potential. When we use the term "larger," we are referring to the height and the width of the price pattern. The height measures the volatility of the pattern. The width is the amount of time required to build and complete the pattern. The greater the size of the pattern—that is, the wider the price swings within the pattern (the volatility) and the longer it takes to build—the more important the pattern becomes and the greater the potential for the ensuing price move.

Virtually all of the measuring techniques in these two chapters are based on the height of the pattern. This is the method applied primarily to bar charts, which use a vertical measuring cri­teria. The practice of measuring the horizontal width of a price pat­tern usually is reserved for point and figure charting. That method of charting uses a device known as the count, which assumes a close relationship between the width of a top or bottom and the subsequent price target.

Differences Between Tops and Bottoms. Topping patterns are usu­ally shorter in duration and are more volatile than bottoms. Price swings within the tops are wider and more violent. Tops usually take less time to form. Bottoms usually have smaller price ranges, but take longer to build. For this reason it is usually easier and less costly to identify and trade bottoms than to catch market tops. One consoling factor, which makes the more treacherous topping patterns worthwhile, is that prices tend to decline faster than they go up. Therefore, the trader can usually make more money a lot faster by catching the short side of a bear market than by trading the long side of a bull market. Everything in life is a tradeoff between reward and risk. The greater risks are compensated for by greater rewards and vice versa. Topping patterns are harder to catch, but are worth the effort.

Volume is More Important on the Upside. Volume should generally increase in the direction of the market trend and is an important confirming factor in the completion of all price patterns. The completion of each pattern should be accompanied by a notice­able increase in volume. However, in the early stages of a trend reversal, volume is not as important at market tops. Markets have a way of "falling of their own weight" once a bear move gets under­way. Chartists like to see an increase in trading activity as prices drop, but it is not critical. At bottoms, however, the volume pick­up is absolutely essential. If the volume pattern does not show a significant increase during the upside price breakout, the entire price pattern should be questioned. We will be taking a more in-­depth look at volume in Chapter 7.

THE HEAD AND SHOULDERS REVERSAL PATTERN

Let's take a close look now at what is probably the best known and most reliable of all major reversal patterns—the head and shoulders reversal. We'll spend more time on this pattern because it is impor­tant and also to explain all the nuances involved. Most of the other reversal patterns are just variations of the head and shoul­ders and will not require as extensive a treatment.

This major reversal pattern, like all of the others, is just a further refinement of the concepts of trend covered in Chapter 4. Picture a situation in a major uptrend, where a series of ascending peaks and troughs gradually begin to lose momentum. The uptrend then levels off for awhile. During this time the forces of supply and demand are in relative balance. Once this distribution phase has been completed, support levels along the bottom of the horizontal trading range are broken and a new downtrend has been established. That new downtrend now has descending peaks and troughs.

Let's see how this scenario would look on a head and shoul­ders top. (See Figures 5.1a and b.) At point A, the uptrend is pro­ceeding as expected with no signs of a top. Volume expands on the price move into new highs, which is normal. The corrective

Figure 5.1a example of a head and shoulders top. The left and right shoulders (A and E) are at about the same height. The head (C) is higher than either shoulder. Notice the lighter volume on each peak. The pattern is completed on a close under the neckline (line 2). The minimum objective is the vertical distance from the head to the neckline projected downward from the breaking of the neckline. A return move will often occur back to the neckline, which should not recross the neckline once it has been broken.

Figure 5.1b A head and shoulder top. The three peaks show the head higher than either shoulder. The return move (see arrow) back to neckline occurred on schedule.

dip to point B is on lighter volume, which is also to be expected. At point C, however, the alert chartist might notice that the vol­ume on the upside breakout through point A is a bit lighter than on the previous rally. This change is not in itself of major impor­tance, but a little yellow caution light goes on in the back of the analyst's head.

Prices then begin to decline to point D and something even more disturbing happens. The decline carries below the top of the previous peak at point A. Remember that, in an uptrend, a penetrated peak should function as support on subsequent cor­rections. The decline well under point A, almost to the previous reaction low at point B, is another warning that something may be going wrong with the uptrend.

The market rallies again to point E, this time on even lighter volume, and isn't able to reach the top of the previous peak at point C. (That last rally at point E will often retrace one- half to two-thirds of the decline from points C to D.) To continue an uptrend, each high point must exceed the high point of the rally preceding it. The failure of the rally at point E to reach the previous peak at point C fulfills half of the requirement for a new downtrend—namely, descending peaks.

By this time, the major up trendline (line 1) has already been broken, usually at point D, constituting another danger sig­nal. But, despite all of these warnings, all that we know at this point is that the trend has shifted from up to sideways. This might be sufficient cause to liquidate long positions, but not necessarily enough to justify new short sales.

The Breaking of the Neckline Completes the Pattern

By this time, a flatter trendline can be drawn under the last two reaction lows (points B and D), which is called a neckline (see line 2). This line generally has a slight upward slope at tops (although it's sometimes horizontal and, less often, tilts downward). The deciding factor in the resolution of the head and shoulders top is a deci­sive closing violation of that neckline. The market has now violated the trendline along the bottom of points B and D, has broken under support at point D, and has completed the requirement for a new downtrend—descending peaks and troughs. The new downtrend is now identified by the declining highs and lows at points C, D, E, and F. Volume should increase on the breaking of the neckline. A sharp increase in downside volume, however, is not critically important in the initial stages of a market top.

The Return Move

Usually a return move develops which is a bounce back to the bot­tom of the neckline or to the previous reaction low at point D (see point G), both of which have now become overhead resistance. The return move does not always occur or is sometimes only a very minor bounce. Volume may help determine the size of the bounce. If the initial breaking of the neckline is on very heavy trading, the odds for a return move are diminished because the increased activity reflects greater downside pressure. Lighter vol­ume on the initial break of the neckline increases the likelihood of a return move. That bounce, however, should be on light vol­ume and the subsequent resumption of the new downtrend should be accompanied by noticeably heavier trading activity.

Summary

Let's review the basic ingredients for a head and shoulders top.

1. A prior uptrend.
2. A left shoulder on heavier volume (point A) followed by a corrective dip to point B.
3. A rally into new highs but on lighter volume (point C).
4. A decline that moves below the previous peak (at A) and approaches the previous reaction low (point D).
5. A third rally (point E) on noticeably light volume that fails to reach the top of the head (at point C).
6. A close below the neckline.
7. A return move back to the neckline (point G) followed by new lows.

What has become evident is three well defined peaks. The middle peak (the head) is slightly higher than either of the two shoulders (points A and E). The pattern, however, is not complete until the neckline is decisively broken on a closing basis. Here again, the 1-3% penetration criterion (or some variation thereof) or the requirement of two successive closes below the neckline (the two day rule) can be used for added confirmation. Until that downside violation takes place, however, there is always the pos­sibility that the pattern is not really a head and shoulders top and that the uptrend may resume at some point.