umed their direction. It may be that two or
   
 
FIGURE 9-3 Double and triple tops.
Resistance
Resistance
Third top oftenfalls short
  
224 CHARTING
GAPS 225
 
three peaks at very similar prices are very unusual and a poor way to trade. A perfect testof the top means that there is uncertainty at that moment and significant selling developedafter the fact.
Now You See It, Now You Don’t!
The “V”-top (actually an inverted V), or spike, is the most difficult top formation to antici-pate and trade. Its frequency in the 1974 and 1980 markets tended to deceive a generationof new speculators. V-tops are caused by critical shortage and demand and magnified bypublic awareness. In 1974, it was a combination of domestic crop shortage, severe pres-sure on the U.S. dollar abroad, and foreign purchases of U.S. grain that combined to drawpublic attention. The news was so well publicized that novice commodity traders withdrewtheir funds from their declining stock portfolios and bought any commodity available as ahedge against inflation.
It could not continue for long. When the top came in soybeans, silver, and most othercommodities, there was no trading for days in locked-limit markets; paper profits dwin-died faster than they were made, and the latecomers found their investments unrecover-able. The public often seems to enter at the wrong time. The case of cattle is an example.
Live cattle prices are based on a combination of consumer demand, substitute foods,current health news, and the price of various feed grains. During 1973 as the price of feedincreased, cattle prices rose steadily from under 40¢ per pound to almost 54¢ in August.Prior to that, live beef prices had never been over 37¢ (in 1952). The price of soybean meal,used as a high-protein feed, continued to move prices higher. How high could it go?Between August and October, live-cattle prices formed a V-top and declined back to under40¢, giving up the 8-month gain in 2 months. How could the supply-and-demand factorschange so quickly? They can’t. Fast rises are always followed by fast, usually extensivedeclines.
The psychology of the runaway market is fascinating. In some way, every V-top sharesa similarity with the examples in Mackay’s Extraordinary Popular Delusions and theMadness of Crowds. With beef, the consumers do not tend to consider pork, fowl, or fishas an adequate substitute and will bear increased costs longer than expected. As pricesneared the top, the following changes occurred:
* The cost became an increasing factor in the standard household budget.* Rising prices received more publicity.
* Movements for public beef boycotts began.
* Grain prices declined due to the new harvest.
This becomes a matter explained by the Elastic Theory. It can be applied to the 1973soybean and 1980 silver markets as well. The Elastic Theory is based on the principle thatwhen prices get high enough, a number of phenomena occur:
. Previously higher-priced substitutes become practical (synthetics for cotton, re-claimed silver). ~ -2. Competition becomes more feasible (corn sweetener as a sugar substitute, alternateenergy).3. Inactive operations start up (Southwest gold mines, marginal production of oil).4, Consumers avoid the products (beef, bacon, silver)
Consequently, the demand suddenly disappears (the same conclusion arrived at by econo-mists). =
Announcements of additional production, more acreage, new products, boycotts, anda cancellation of orders all coming at once cause highly inflated prices to reverse sharply.
 
 
These factors form a V-top that is impossible to anticipate with reasonable risk. There is anatural reluctance to take profits while they are still growing. Further impetus is given tothe reversal because of the scramble to liquidate after the first reversal day. This is followedby those latecomers or pyramiders who entered their most recent positions near the topand cannot afford a continued adverse move. The rush to close out long positions, put onnew shorts, and liquidate deficit accounts only prolongs the sharpness of the V-top, caus-ing a liquidity void at many points during the decline.
Quantifying SpikesA spike is often the focal point of a trade. Most often it represents a severe reaction to anevent, but it may be an island reversal representing a new direction. A spike is importantbecause it always indicates high volatility and exceptional risk and cannot be ignored. Aspike has only one dominant feature, a price high or low much higher or lower than recentprices. This must result in volatility that is equally extreme. The easiest way to identify anupside spike is to compare the day’s trading range with previous ranges and to the nextday. This can be done by using the average true range and satisfying both the followingconditions:
High today ~ @highest(high,n) > K x average true range(7)High today — high tomorrow > K x average true range(1)
 
‘Today’s spike high must be higher than the highs of the previous 7-days by a multiple, K,of the average true range; it must also be higher than tomorrow's high if it is to stand outasa spike.
GAPS
A gap is a formation caused by a jump in price from one point to the next and can be cal-culated as
Gap = @AbsValue(open - close{1])
Gaps are phenomena that make sense only when trading is restricted to local businesshours. A currency trader with 24-hour capability has, theoretically, a very small chance ofconfronting a gap. Most gaps are overnight moves, where continuous events causechanges in price levels; when the exchange or banks open for business the price immedi-ately jumps to the new level. A market with very large relative gaps is the Japanese yen trad-ing in Chicago. During the Japanese business day, when most relevant news occurs, theInternational Monetary Market (IMM) is closed; when the IMM is open, most businesses inJapan are closed. The Chicago market is therefore always trying to catch up to the price ofthe dollar/yen as seen by the Japanese. -
There is also a technical situation associated with price gaps. Traders place moreorders to buy at a point near or just above a resistance level; similarly, they place sell ordersjust below support lines. This causes fast moves and a void of orders when resistance andsupport are penetrated. Gaps also occur after a price shock or any unexpected new releaseor economic report.
‘A gap appears as an open area on a chart created by prices trading entirely above orbelow the prior trading range. Gaps will usually occur at the opening of the day, a newsrelease, or where prices break out of a clearly identified formation, such as a long-termtrendline, a consolidation area, or during a prolonged major price move. Regardless of thereason, it is the consequence of a lack of speculators willing to take the opposing positioncausing a thinly traded or illiquid market. In the most interesting situations, the break-away gap is the name given to the result of many stop-loss orders placed at new highs or 
226 CHARTING
lows, at major trendlines as,protection against unfavorable breakouts with respect to exist-ing positions, or as an entry to a new position. The breakaway gap usually signifies achange from the previous, well-established pattern.
The common gap is the least glamorous. It occurs within a well-defined trading rangeor pattern, and is not indicative of a change of direction nor does it have other specialattributes; hence it is called “common.” Both runaway gaps and midway gaps refer tothose price jumps occurring within a strong trend. They are associated with periods ofilliquidity within a move; this could be the result of additional news to encourage the bullsor bears, or it could be a critical chart formation or anticipated reversal point that fails.Runaway gaps indicate stronger moves.
The exbaustion gap or island reversal is the culmination of a major move; unfortu-nately, it is a formation only identifiable after the fact. If the price move has been excep-tionally extended, it is likely that the first gap reversal will be the beginning of the trendchange; however, there is a great risk associated with it.
Gaps are a hindrance rather than an asset to trading. A breakaway gap usually causesstop-loss orders to be executed far away from the stated price. If a long position is enteredin anticipation of a breakout, that breakout never occurs and a high price is guaranteed. Ifthe breakaway gap occurs on light volume, a position might be entered on a pullback. Inthe final analysis, if the breakout represents a major change, a trade should be enteredimmediately at the market price. The poor executions will be offset by a single time whenprices move quickly and no pullback occurs. A breakaway gap on high volume should bemore indicative of such a major change.
Many traders believe that prices will retrace and “fill the gap” that occurred sometimeearlier, There are analysts who never give up, but waiting to fill a gap that is more than twoyears old may be carrying this technique too far. There is no doubt that the gap representsan important point at which prices move out of their previous pattern and begin a newphase. The breakaway gap will often be a position just above the previous normal pricelevel. Once the short-term demand situation has passed, prices should return to near nor-mal (perhaps slightly above the old prices), but also slightly below the gap.
 
    
KEY REVERSAL DAYS
A formation that has been endowed with great forecasting power is the key reversal day,sometimes called an outside reversal day. It is a weaker form of an island reversal. A bear-ish key reversal is formed in one day by first making a new high in an upward trend, revers-ing to make a low that is lower than the previous low, and then closing below the previousclose. It is considered more reliable when the prior trend is well established. This could beidentified using EasyLanguage asKeyReversalDown = 0;@if close[i] > @average(close(1],n} and high >= @highest(high(1J,n) and
low < lowtl] and close < close[1] then KeyReversalDown = 1;
where the first term tests for an uptrend over n-days, the second tests that this day is the
highest price of the Same n-days, the third verifies a lower low, and the last tests a lower
close.
Studies have shown mixed results using the key reversal as a sole trading indicator. Themost complete analysis,”° similar to others, concluded that the performance was “strikinglyunimpressive.” Even though tests have not proved its importance, traders still pay closeattention to key reversals. Based on this, it must be concluded that other factors uncon-sciously enter into the normal perception of a key reversal. A trader's senses should not be
'© Bric Evans, “Why You Can’t Rely on ‘Key Reversal Days’,” Futures (March 1985).
EPISODIC PATTERNS - 227
underestimated; the extent and speed of the prior trend, a change in liquidity, a quietertone, or some external news may be essential in confirming the important reversals.
Pivot Point Reversals and Swings
A pivot point is a trading day, or a price bar, that is higher or lower than the bars that comebefore and after. It is the common form of an island reversal and a popular way of identi-fying turning points. The most frequent pivot point high is a bar that has a higher high thanone day before and one day after. More significant swing highs can be found by comparingthe high of any day with two or more days before and after. This is the method used inTradestation’s “Swing, High Bar” function. The pattern of the days on either side of thehigh bar are not important as long as the middle bar has the highest high.
Pivot points are used as the basis for finding swing highs and lows, and they identifythe extremes of both price and oscillator for TradeStation's divergence functions. Forexample, if the last two price pivot points correspond to the same days as the last two sto-chastic or RSI pivot points, and prices are rising while the momentum is falling, there is abearish divergence. When more days are used to identify pivot points, these divergence sig-nals are expected to be more significant; unfortunately, they take longer to identify.
Cups and Caps
Another name given to the pivot point reversals are cups and caps, each determined byonly three price bars. These two formations are associated with trading rules that are iden-tical to pivot point channels applied to the shortest time frame. Contrary to their names, acup formation identifies a sell signal when the trend is up, while a cap is a setup for a buysignal in a downtrend. Once an uptrend is clear, a cup formation is found using either thedaily closes or daily lows. For any 3 consecutive days, the middle day must have the lowestClose or the lowest low. In a cap pattern the middle day must have the highest high or thehighest close of the 3-day cluster. In both cases, the positioning of the highs and lows ofthe other 2 days are not important as long as the middle day is lower for the cup and higherfor the cap.‘The cup will generate a sell signal if:
 
1. The cup formation is the highest point of the uptrend.2. The sell signal occurs within 3 days of the cup formation. ;3, The current price closes below the lowest low (middle bar) of the cup formation.
‘The signal is false if prices reverse and close above the high of the cup formation, resum-ing the previous trend. This pattern is only expected to forecast a downward Price move o!two days; however, every change of direction must start somewhere, and this formationn edge. A cap formation is traded with the opposit .coe odin to tests by Colby and Meyers," entries that occur based on a breakout of ithehighs or lows of the pivot points, called pivot point channels, are much more reliab le ‘ hansimply entering in the direction of the reversal based on the close of the last bar 0 thepivot point, cup, or cap formation, For traders not interested in this very short-term s\egy, a pivot point may help entry timing for any longer-term method.
EPISODIC PATTERNS
‘There is litte argument that prices change quickly in response to unexpected news. Thetransition from one major level to another is termed an episodic pattern; when these tran-
«Tests of pivot point reversals and pivor point channels can be found in Robert W. Colby and Thomas A. Meyers,The Encyclopedia of Technical Market Indicators (Dow Jones-Irwin, 1988) 
228 CHARTING
sitions are violent, they are-called shocks. The coffee and oil markets have received thegreatest number of shocks; however, all markets are continually adjusting to new price lev-els, and all experience occasional shocks.
The pattern that results from episodic movement is exactly what one might expect. Fol-lowing the sharp price movement there is a period when volatility declines from its highs,narrowing until a normal volatility level is found and remains at that level (Figure 9-4).
Patterns that result from rising prices are not the same as falling prices. Althoughhigher price moves usually overshoot the price level at which they normally settle, sharpdeclines do not reach their final levels during the first shock.
Price shocks have become the focus of much analytic work. Because a price shock is anunpredictable event, it cannot be forecast. This has a critical effect on the way in which sys-tems are developed, especially with regard to the testing procedures. This topic is coveredin other parts of this book under the topics “Price Shocks,” “Robustness,” and “Optimiza-tion.”
 
PRICE OBJECTIVES FOR BAR CHARTING
There is some satisfaction in having a price objective for a trade that has just been entered.If this objective can be determined to a reliable degree, those trades would be selected thathave the best profit potential as compared with the risk. It is also comforting to know thatprofits will be banked at a specific point. The most successful objectives will be based onstraightforward concepts and not complex calculations.
The simplest and most logical price objective is a major support or resistance levelestablished by previous trading. When entering a long position, look at the most well-defined resistance levels above the entry point. These have been discussed in a previoussection of this chapter, “Tops and Bottoms.” When those prior levels are tested, there isgenerally a technical adjustment or a-reversal. In the case of a strong upward market,volatility often causes a short penetration before the setback occurs. Placing the priceobjective a reasonable distance below the identifiable major resistance level will always besafe; the intermediate resistance levels can be used for adding positions on technical rever-sals, The downside objective can be identified in a similar manner: Find the major supportlevel and place a stop just above it. -
 
FIGURE 9-4 Episodic patterns. (0) Upward price shocks. (b) Downward price shocks.
PN
 
   
Congestion‘ShockStabilization
(2) (b)
 
PRICE OBJECTIVES FOR BAR CHARTING 229
When using both support and resistance price objectives, watch carefully for a viola-tion of the current trend; don’t be rigid about the position. Take advantage of each reac-tion to add to the position, but get out if the major trendline is broken before the objectiveis reached. On the other hand, if the goal is reached and prices react as predicted but thenreverse and break through the previous highs or lows, the trade may be reentered on thebreakout and a new price objective calculated.
‘There are other, more analytic ways to determine the objective ofa trade. Bear in mindthat these methods are considered guidelines and are not precise. If you have set a singleprice target for a long position, and it falls slightly above a resistance level, then the resis-tance level (the closer point) should be substituted for an original price objective.
The head-and-shoulders top has a downside objective that is associated with its volatil-ity. This objective is measured from the point where the right shoulder penetrates theneckline and is equal to the distance from the top of the head to the neckline (Figure 9-5).For a major top, this goal seems modest, but it will be a good measure of the initial reac-tion and will generally be safe, even if a new high price is reached later.
For a consolidation area, both top and bottom, a counting method based on thewidth of the rectangle or consolidation pattern is used to find the price target. For a bas-ing formation, the objective is the vertical distance above the support line equal to thewidth of the consolidation area (Figure 9-6). For downside objectives, measure verticallydownward from the resistance line forming the upper bound of the congestion area, a goalsimilar to the head-and-shoulders top. This technique implies that the longer the consoli-dation area, the bigger the subsequent breakout. The same method can be seen later inpoint-and-figure charting.
Trendlines can also be used to measure the expected price move. The most commontechniques are based on channel volatility and, therefore, set very modest, realistic targets.
1. The channel width, which bounds a trend, will be equal to the price objective mea-sured from the point of the channel breakout (Figure 9-7).
 
FIGURE 9-5 Head-and-shoulders top price objective.
   
Breakoutofneckline =
Priceobjective
  
30 CHARTING PRICE OBJECTIVES FOR BAts CHARTING 231
FIGURE 9.6 Consolidation price objective. expected to be too precise duc to the early development of the channel. If prices continueto point c and then rally to d, a more reasonable channel can now be defined using trene-
Price lines 2R and 2S. The support line will again become the point where the new price objec”objective tive is placed. The upper and lower trendlines can be further refined as the pew high andlow reactions occur. The primary trendline is always drawn first, then the new price objec-tive becomes a point on the parallel trendline.
Triangles and flags bave objectives paced on volatility in a manner consistent withother patterns. The triangle objective is equivalent in size to the initial reaction, whichformed the largest end of the ‘riangle (Figure 9-9a). The flag is assumed to occur midwayina price move; therefore, the objective ofa new breakout must be equal to the size of themove preceding the flag (Figure 9.96). Recalling the comments on the problems associatedwith the decreasing volatility of the triangular formation, the use of the first reaction as ameasure of volatility is a safe way to avoid those problems.
           
Resistance
The Rule of Seven
‘Another measurement of price objectives, the Rule of Seven, is credited to Arthur Sklarew.'?It is based on the volatility of the prior consolidation formation and computes three successive price objectives in proportiot to one another. The Rule of Seven is not symmetricfor both uptrends and downtrends. Sklarew believes that, after the initial leg of a move, thedowntrend reactions are closer together than. the reactions in a bull market. Because thedownside of a major bear market is limited, it is usually characterized by consolidation.Major bull markets tend to expand as they develop.
1 ‘Support tj~_———— D
ee
2, Once a breakout of an upward channel has occurred, construct a new descendingchannel. This is done by connecting the high of the uptrend with the high of theit reverse howe the break, then drawing a parallel support line across the "To calculate the objectives using the Rule of Seven, first measure the length L of the ini-low of the first breakout. The new channel will be shallow but will serve as a guide- tial leg ofa price move (from the previous high or low, the most extreme point before theline for the price change. A second channel, drawn after the next reversal, should. first pullback). The objectives are:indicate the final direction of the new move.
in Figure 9-8, the original channel around the uptrend was broken at the point marked 4. In an uptrend:
by the black dot, followed by prices moving down to point @ and reacting back up to point By 1= prior low + Ex 7/9)b, When 2 new high is not made at int b, a resistance line (1R) can be drawn from theprior high b to the top of the latest move b. Aline parallel to 1R can be constructed at point 0B} 2 = prior low + * 7)
a, forming the initial downward channel. Price objective 1 is on the support line.of the new :
“pannel (1S) and is used once the top at point b is determined. Price objective 1 cannot be 08) 3= prior low + E77?)
 
      
 
 
FIGURE 9-7 The channel width as a price objective, 2 gklarew. (See reference 8.)Price ‘ _erreven rei —objective 1 FIGURE 9-8 Forming new channels £0 determine objectives.
 
First point of reversal
 
Priceobjective #1
    
  
Priceobjective #2 
232 CHARTING
 
eeFIGURE 9-9 Triangle and flag objectives. (a) Triangle objective is based on the width of theinitial side, s. (b) Flag objective is equal to the move prior to the flag formation.
objective
7'
objective ’4
|||ilhi1!1|
   
(a) . (b)
 
2, In a downtrend:OBJ 1 = prior high — (L x 7/5)OBJ 2 = prior high — (£ x 7/4)OBJ 3 = prior high - (L x 7/3)
‘The three objectives apply most clearly to major moves. During minor price swings itis likely that the first two objectives will be bypassed. In Sklarew’s experience, regardlessof whether any one objective is missed, the others still remain intact.
CANDLESTICK CHARTS
For a technique that is reported to have been used as early as the mid-1600s, Japanese can-dle charts were slow finding their way into the western method of analysis. In actuality,candle charts only differ from simple bar charts by shading the piece of the bar between_the opening and closing prices—white if the close is higher than the open and black if theclose is lower than the open. The shaded area is called the body, and the extended linesare the shadows. With this simple change, we get an entirely new way of looking at andinterpreting charts, The patterns become much clearer than the western style of line chart.Over the centuries many of the candle formations have been given names representingtheir significance (see Figure 9-10): ~
Doji—in which the opening and closing prices are the same.Hammer—a bullish reversal signal, showing the bottom of a swing, where the body is
at the top of the candle, indicating an upward change of direction, and the shadow isbelow the body. The body may be black or white.
Hanging man—another bearish reversal pattern where the body of the candle repre-sents the high of a swing, and the shadow lies below in the direction of the reversal.The body may be black or white.
 
CANDLESTICK CHARTS 233
 
 
FIGURE 9-10 Popular candle formations.
 
boy! HAMMERHigh, High \ |Open and Io! |CloseOpen Nye ornt itow pen ar Black(a) (b)HANGING MAN SHOOTING STAR
i or Black L- White or Black| |
1 |
|
|I
(C) (a)
 
BULLISH ENGULFINGPATTERN1
‘yg ; '
Source: Jack D: Schwager, Schwager on Futures:Technical Analysis (John Wiley & Sons, 1996, pp. 281-288).
BEARISH ENGULFINGPATTERNoh,| \
“
Shooting star—a bearish signal, also occurs at the top ofa swing and has its body at thebottom of the candle with the shadow above. The body may be black or white.
Engulfing pattern—occurring at a swing high or low, bas the current body engulfingthe entire prior candle.
Although these patterns are similar to western bar chart formation, none of them areexactly the same. The hammer, hanging man, and shooting star are reversal patterns butcan only be compared with the simple pivot point, where the middle day is higher orlower than the bars on either side. None of these candle formations would be a keyreversal or island reversal. The engulfing pattern is stronger than the typical outside day,because the spanning of the prior day’s range must be done only by the current day'sopen-close range.
The analysis of candle charts is a skill involving the understanding of many complexand interrelated patterns. For a brief review of this method, readers are referred to Schwa-ger on Futures: Technical Analysis; for full coverage, Japanese Candlestick Charting Tech-niques (New York Institute of Finance, 1991), and Beyond Candlesticks—New JapaneseTrading Techniques, both by Steve Nison, are recommended. 
234 CHARTING
 
Quanti
‘The preciseness of the candle formations allows some patterns to be tested. One techniqueuses the shadows as confirmation of direction. We can interpret an increase in the size ofthe upper shadows as strengthening resistance (prices are closing lower each day); and anincrease in the size of the lower shadows represents more support. One way to look at thisis by defining
Upper shadow (white) = high — close Lower shadow (white) = open — low
 
ing Candle Formations
Upper shadow (black) = high - open —_ Lower shadow (black) = close — low
The sequences of upper and lower shadows can be smoothed separately using a movingaverage to find out whether they are rising or falling.’*
Another method for determining whether black or white candles dominate recentprice movement is to use only the body of the candle, B = close — open and apply a momen-tum calculation
BBody momentum = ——2—— x 100° Buy + Boownwhere By, is the sum of the days where B > 0 (body is white)Baown is the sum of the days where B < 0 (body is black),the number of days is recommended as 14.
When the body momentum is greater than 70 the whites dominate; when the value isbelow 20 the blacks dominate.
USING THE BAR CHART
Charting is not precise and the construction of the trendlines, other geometric formations,and their interpretation can be performed with some latitude. When using the simplesttrent analysis, it often happens that there will be a small penetration of the channel ortrendline followed by a movement back into the channel. Some think that this inaccuracy,with respect to the rules, makes charting useless; however, many experienced analystsinterpret this action as confirmation of the trend. The trendline is not redrawn so that thepenetration becomes the new low of the trend, but it is left in its original position.
‘We must always step back and look for the underlying purpose in each method of analy-sis, whether technical or fundamental. In the case of the trendline we are trying to identifythe direction of prices over some time period. Chartists can use a simple straight line tovisualize the direction; they draw the uptrend by connecting the lowest prices in a risingmarket even though each point used may represent varying levels of volatility and uniqueconditions. The chances of these points aligning perfectly, or forecasting the perfect pricesupport level, is small. A trendline is simply a guide; it may be too conservative at one timeand too aggressive another; you'll never know. Applied rigorously, charting rules shouldproduce Many incorrect signals but be right in the most important cases. The challenge ofthe chartist is to Interpret the pattern of prices in context with the bigger picture.
 
Multiple Signals
Some of the impreciseness of charting can be offset with confirming signals. A simultane-‘ous short- and long-term trend break is a much stronger signal than either one consideredseparately. The break of a head-and-shoulders neckline that corresponds to a channel sup-
3 Both shadow trends and body momentum are adapted from Tushar Chande and Stanley Kroll, Te New Tech-nical Trader (John Wiley & Sons, 1994).
USING THE BAR CHART 235
port line is likely to receive much attention. Whenever there are multiple signals converg-ing at, or near, a single point, whether based on moving averages, Gann, cycles, or phasesof the moon, that point gains significance. In chart analysis, the occurrence of multiple sig-nals at one point can compensate for the quality of the interpretation.
Pattern Failures
The failure to adhere to a pattern is equally as important as the continuation of that pat-tern. Although a trader might anticipate a reversal as prices near a major support line, abreak of that trendline is significant in continuing the downward move. A failure to stop atthe support line should result in setting short positions and abandoning plans for higherprices.
A head-and-shoulders formation that breaks the neckline, declines for a day or two,then reverses and moves above the neckline is another pattern failure. Postpattern activitymust confirm the pattern. Failure to do so means that the market refused to follow throughand, therefore, should be traded in the opposite direction. This is not a case of identifyingthe wrong pattern; instead, price action actively opposed the completion of the pattern.Wyckoff calls this “Effort and Results,” referring to the effort expended by the market toproduce a pattern that explains the price direction. If this pattern is not followed by resultsthat confirm the effort, the opposite position should be set.
Consider a trading day in which prices open above the previous close, move higher, thenclose lower. The expectation is for prices to open lower the next day. If an inside day or ahigher open follows, there is a strong sign of higher prices to come. As Thompson concludes,“A strongly suggestive pattern that is aborted is just as valuable as a completed pattern.”
Change of Character
Thompson also discusses the completion of a pattern or price trend by identifying achange of character in the movement. As a trend develops, the reactions, or pullbacks,tend to become smaller. Traders looking to enter the trend wait for reactions to place theirorders; as the move becomes more obvious, these reactions will get smaller and the incre-ments of trend movement will become larger. When the reaction suddenly is larger, themove is ending; the change in the character of the move signals a prudent exit, even ifprices continue erratically in the direction of the