Volume Trading Strategy: Identifying Trend Reversal Patterns

THE VOLUME ALERT: IDENTIFYING TREND REVERSAL PATTERNS

So far in our Volume Analysis, we have explored a variety of trading tools and methods to identify chart patterns and assess trends. A trend reversal pattern can occur intraday, lasting a few hours; short term, lasting a few days to a few weeks; or long term, lasting several months. The recognition of reversals is a critical skill in the trader’s toolbox; it is typically easier to spot and follow trends, but also easier to “get burned” when a reversal signal is missed. A great degree of analysis and insight is required to spot reversal patterns, and the ability to do so can set you apart from the average trader. Chapter 5 focuses specifically on identifying trend reversal patterns.

These chart patterns contain volume behavior that provides insight into the conviction of the trend and can alert us to perhaps the most critically important patterns in the market for traders. In our Volume Analysis, we will examine examples of broad-market trend reversals, index reversals, and the reversals of individual issues. We will look at longer-term “macro” trend reversals and shorter-trend reversals, of interest only to an intraday trader. What to keep in mind when examining these charts is the trader’s mantra: volume precedes price. The intensity of a reversal may come as a surprise, but the reversal itself never should. The market flashes warning signals, and the volume behavior within these patterns is an early alert that a change in sentiment and trend is underway.

Macro, or Longer-Term, Trend Reversals

Using Volume Analysis, we identified the price trend and assessed under what circumstances we might anticipate a reversal. In this section, we focus our attention on actual trend reversal patterns. All the reversal patterns that we will be discussing can occur in the broad market, in an index or commodity, or in an individual issue. Our first three examples display simple trend reversal patterns in the macro, or longer-term, prevailing trend.

Chart 5.1 for the iShares Russell 2000 Trust ETF (IWM) shows how the volume pattern tipped traders off that a change in price direction was coming in the summer of 2007. Price had been in an uptrend (a pattern of higher highs and higher lows) since March 2003 (the full trend duration is not shown, in order to scale recent events properly).

As price made new highs in May and June 2007, seen in area A, the price pattern became choppy. Looking at price alone would tell you that IWM was in a consolidation phase, but that's about it. When volume is included in the analysis, however, the picture becomes clearer. Notice how volume activity increased during this choppy phase. Following a trend, choppy price action combined with an increase in volume is a sign of distribution. Every time eager buyers entered the market, there were

Chart 5.1 Classic Volume/Price Reversal Scenario, iShares Russell 2000 Trust ETF

sellers willing to take profits and give up their shares. The elevated supply held price in check, which prevented any further upward push in price.

In area B, the overhead supply proved too much for the market to bear, which prompted sharp selling into August. At that point, a trend reversal was definitely taking shape, but we needed one more piece of evidence before making that call. That piece of evidence was the behavior of volume on the next rally attempt in area C.

Note how, on the rally attempt following the August sell-off, the volume contracted as price moved higher and approached the summer 2007 highs. This was a definite sign that there was not enough fuel in the tank (volume) to push prices significantly higher, which opened the door for a sell-off (area D). Notice the consistently higher level of volume during the sell-off as compared to the previous rally attempt in area C. That showed a definite shift in trader sentiment and that sellers were firmly in control.

Just as a volume spike in a strong uptrend can alert traders that buying pressure has exhausted itself in the market, a spike in volume following a steep downtrend can also alert traders that sellers have exhausted them-selves in a fit of panic selling.

Note in Chart 5.2 for IBM that the volume pattern is rather consistent throughout the three-month downtrend from December 2004 through

Chart 5.2 Trend Reversal with Spike and Consolidation, IBM

 April 2005. In mid-April, however, volume spiked higher as price dropped sharply to a new low. The sharp increase in volume showed that sellers wanted out so bad that they were willing to dump shares on the market in order to protect themselves from further losses. This type of seller behavior usually marks a low point in sentiment. Note also how price chopped sideways in a three-month consolidation pattern before reversing and moving higher.

Reversal Off an Intense Downtrend

Intense downtrend reversals are characterized by falling prices with noticeably rising volume. While the previous example in IBM showed steady selling with a consistent volume pattern, the intense downtrend shows true and strong negative sentiment.

Chart 5.3 for the S&P Industrial Select SPDR ETF (XLI) shows a new downtrend developing in May 2008. Note how volume increased throughout the sell-off as price was making a series of lower lows and highs. This type of intensity reflected increasing negative sentiment, as traders looked to eliminate further loss.

The consistently high volume in October and November 2008 confirmed that negative sentiment toward XLI was still very strong. After a brief

 

Chart 5.3 Reversal Off Intense Downtrend, S&P Select Industrial SPDR ETF

rally from late November into early January 2009, price once again headed lower, this time making a new low. As the new low was made, notice how volume decreased as price pushed lower. This change in the volume pattern showed that negative sentiment was waning. This meant selling pressure had weakened, indicating that a trend change was imminent.

Short-Term Reversals and Overlays

In the previous three examples, we concentrated on long-term macro trend changes based on our Volume Analysis over a period of months. What about changes in volume patterns for the more active trader wishing to capitalize on short-term price movements? One solution lies in the use of volume overlays. In this section, we will concentrate on the use of volume moving averages (VMAs), first introduced and explained in Chapter 4.

Shorter-period VMA parameters show changes in volume patterns useful for the active trader to spot short-term trends. The key to selecting the proper time frame for your VMA is to pick a length that is neither too short (which can lead to trading whipsaws) nor too long (which can lead to “indicator lag,” or the generation of late signals).

In our Volume Analysis of short-term reversals, we chose a 9-period exponential moving average (EMA) to use with our daily charts. An EMA, which weights more recent data more heavily, is favored over a simple, or linear, moving average for this purpose because of its sensitivity to recent data and thus its ability to reveal more recent volume shifts.

When examining the behavior of the VMA, traders should note its dual ability to both confirm a trend and signal a potential reversal. In the following discussion, we note the volume pattern of the VMA under different market conditions. In an uptrending market, an increasing VMA confirms that trader sentiment is positive, as buying pressure forces prices higher. A VMA that peaks and begins to turn lower in an uptrending market signals that buying pressure has temporarily peaked, which provides an early alert to a pullback or to a potential reversal in trend. In a declining market, a rising VMA indicates that trader sentiment is negative, since selling pressure drives price movement lower, confirming the downtrend. Once the VMA peaks and moves lower in a downtrending market, it signals that selling pressure has diminished, thus providing an early alert to a rally or potential reversal.

Chart 5.4 for the S&P 500 SPDR ETF (SPY) shows how the 9-day VMA can be used to pinpoint short-term lows in the market. Note how 

Chart 5.4 Reversals Signaled by 9-Day VMA Overlay, S&P 500 SPDR ETF 

each time the VMA peaked after moving higher, a short-term trading bottom was formed in the market

Chart 5.5 of the Nasdaq 100 Trust ETF (QQQQ) shows the 9-day exponential moving average at work there also. This overlay tends to show more bottoms than tops because of the more emotional nature of market participants (elevated volume) during sell-offs, but notice in the QQQQ chart how the 9-day VMA caught a couple of swing highs in QQQQ in March and June 2009.

Reversals Signaled by MACD Volume Overlay

It’s worth looking at the same chart of QQQQ using the same volume principle, only this time using the Moving Average Convergence/Divergence (MACD) volume overlay (see Chart 5.6). This is a more sensitive overlay, as it shows more frequent and more clearly defined peaks. Notice how each time the MACD of volume peaked well above the zero line and turned lower, price changed short-term direction. This alerted the active trader to short-term changes in direction, which could be used for taking profits or initiating new positions.

Chart 5.5 Reversals Signaled with 9-Day VMA Overlay, Nasdaq 100Trust ETF

Chart 5.6 Reversals Signaled with MACD Overlay, Nasdaq 100Trust ETF

Volume Behavior in Trend Reversal Patterns

Every trend reversal pattern requires some pattern of volume in its development. In Volume Analysis, we interpret this volume pattern to either confirm the reversal pattern or refute it. The identification of these patterns can help a trader who trades with the trend to lock in profits and step aside, while a short-term trader may choose to catch the reversal. Either way, the goal here is not to get “caught” in a reversal, and volume patterns give plenty of warning signals to avoid them. In this section we will look at several widely identified reversal patterns.

The Wedge

A wedge is a chart pattern constructed by two converging lines connecting a series of price peaks (resistance) and price lows (support). It is like a pennant or symmetrical triangle pattern (discussed in Chapter 4), except that it usually occurs in a rising or falling, not a horizontal, direction. The wedge reversal pattern is typically longer term in nature, lasting anywhere from three to six months. In order for a wedge pattern to be a valid reversal pattern, however, there must be a prior trend in place to reverse. There are two types of wedge patterns, rising and falling.

Falling Wedges

The falling wedge has bullish implications, as it normally breaks up out of the wedge to begin an uptrend. The boundary lines of this pattern converge, with each slanting downward as the pattern forms. Another characteristic of a falling wedge is that the upper boundary line (or resistance line) normally has a sharper slope than the lower boundary line (or support line) in the pattern. A flatter support line shows that selling pressure is diminishing, as sellers are unable to push the price down much farther with each new round of selling.

Price should touch each line (support and resistance) at least twice during the formation of the pattern. The more times the boundary lines are touched, the more reliable the pattern is thought to be. During the formation of the pattern, volume generally lightens as the wedge develops, showing a lack of conviction among both buyers and sellers.

A buy signal is given when price breaks through the upper resistance line. The breakout should be confirmed by heavier volume, but price must also confirm the breakout by posting successive closes above the upper resistance line. Chart 5.7 for Starbucks (SBUX) shows how volume drops

Chart 5.7 Bullish Reversal, Falling Wedge Pattern, Starbucks Corporation

as the pattern is formed and then explodes on the bullish breakout, sending prices sharply higher.

Rising Wedges

A rising wedge has bearish implications, as price normally breaks out to the downside to resolve the pattern and begin a downtrend. Price movement contracts (i.e., narrows) as the pattern develops, showing that upside momentum is slowing. The top line (resistance) typically has a flatter slope than the bottom line as it pushes higher, showing diminishing buying pressure as the pattern progresses.

A sell signal is given when price breaks below the support line. As with the falling wedge, the breakout should be confirmed by heavier volume. The breakout must also be confirmed by price posting two successive closes below the support line. Cisco Systems (CSCO) in Chart 5.8 shows the low-volume pattern as the rising wedge forms, followed by the volume explosion on the downside breakout. 

The Head-and-Shoulders Reversal Pattern

The standard head-and-shoulders reversal pattern forms after an uptrend; it signals a bearish reversal. It consists of three peaks, with the middle peak

Chart 5.8 Bearish Reversal, Rising Wedge Pattern, Cisco Systems

(the head) being higher than the other two (the shoulders). The shoulders are typically (but not always) equal in height. The reaction lows of the first two peaks (i.e., the left shoulder and the head) can be connected to form the “neckline,” or signal line. Chart 5.9 illustrates the pattern. The head- and-shoulders pattern signals a top as the last bits of buying energy come into a stock or contract. The “head” is the final upsurge, with the right shoulder representing a smaller surge of “late” buyers coming to the party, only to be eventually disappointed. Buyers may make more than one weak attempt to push prices higher, as is described shortly.

Volume plays a very important role in confirming the head-and-shoulders pattern as it develops. Volume should be lighter on the head than on the left shoulder, and volume should be lighter on the right shoulder than on the head. The most critical of the three peaks, however, is the right shoulder. Volume should contract noticeably, signaling that buying interest in the security is weakening, which indicates that a change in sentiment is underway. Volume should increase on the downside break of the neckline, showing that selling pressure is building. Following the neckline break, there is usually one more rally back up to the neckline, which should act as resistance. The rally to “test” the neckline should be on lighter

Chart 5.9 Standard Head-and-Shoulders Reversal Pattern

volume than the downside break of the neckline. Prices should then roll over one more time on expanding volume to indicate that a new downtrend is underway.

The chart of the Dow Jones Industrial Average Diamonds Series Trust ETF (DIA) in Chart 5.10 shows a typical head-and-shoulders reversal pattern. Notice the distinct peaks at the top of the chart that form the left shoulder, head, and right shoulder. A head-and-shoulders reversal pattern is not readily apparent until the pattern corrects from the head and begins to form the right shoulder. At this point, the pattern should be watched, but nothing more. Notice that as the right shoulder formed, volume dropped, signifying that there was insufficient demand to push price back to the high (the head).

As price pushed lower from the right shoulder, it broke down through the neckline as volume increased dramatically. This shows that sentiment had changed and that sellers were in control. Price then consolidated for two months before rallying up to test the neckline in March into May 2008. As price approached the neckline, volume decreased, confirming the negative sentiment. Once price touched the neckline and was unable to break through, volume picked up again as price resumed its downtrend.

 Chart 5.10 Bearish Reversal, Head-and-Shoulders Pattern, DJ Diamonds Trust ETF

Calculating Price Targets with Head-and-Shoulders Patterns

The head-and-shoulders reversal pattern allows accurate price targets to be generated. Price targets are computed by measuring the distance between the head and the neckline. That amount is projected lower from the point of penetration of the neckline after the right shoulder is formed. Projections from these formations can give a trader a price area to look for support and possible long entry, depending on other confirmatory indicators. Chart 5.11 shows the price target projection methodology.

Using the DIA chart from Chart 5.12, we can examine the price projection that could be generated by the head-and-shoulders formation noted previously. The price calculation is as follows:

• Project straight down from the high point of the head ($141.95) to the value of the neckline ($126.40) on that particular day.
• Subtract the value of the neckline from the high: $141.95 - $126.40 = $15.55.
• When the neckline is broken (after the right shoulder is formed), subtract $15.55 from the value of the neckline on the day it was broken: $128.15 - $15.55 = $112.60.

 Chart 5.11 Projecting Price Targets with Head-and-Shoulders Patterns

 Chart 5.12 Projecting Price Targets, Head-and-Shoulders Patterns, DJ Diamonds Trust ETF

Once the price target is reached, it is more of a signal to take profits on short positions than a blind buy signal for those looking to get long. Whenever looking to initiate a new position, always make sure that other indicators confirm the fact that a bottom may be in place. Notice how after a brief period of consolidation, the price for DIA turned lower yet again, as sentiment toward it remained negative.

Inverse Head-and-Shoulders Pattern

The inverse head-and-shoulders is a bullish pattern, essentially the “upside-down” version of the standard head-and-shoulders reversal pattern, and it is formed at price lows. It is just as reliable as the head-and-shoulders formations at highs, only the chart pattern is inverted. The same volume characteristics apply during the formation of the pattern, as it should be weakest at the formation of the right shoulder and explode higher on an upside break of the neckline.

In Chart 5.13 for Amazon.com (AMZN), notice how volume is subsequently weaker from the left shoulder to the head and from the head to the right shoulder. As price gaps up through the neckline, volume explodes higher, showing that sentiment is positive and a new uptrend is beginning.

Chart 5.13 Bullish Reversal, Inverse Head-and-Shoulders Pattern, Amazon.com

The inverse head-and-shoulders pattern projects price targets in the same manner as the head-and-shoulders reversal pattern at tops:

• Project straight up from the low of the head ($34.68) to the value of the neckline ($59.33) on that particular day.
• Subtract the low from the value of the neckline:
• $59.33 -$34.68 = $24.65.
• When the neckline is broken (after the right shoulder is formed), add $24.65 to the value of the neckline on the day it was broken: $57.25 + $24.65 = $81.90.