and low volatility, much the same as a double bottom. Prices show an inability to go lower because investors are willing to accumulate a position at agood value.
SpikeIslandreversal
A rare triple top
Exceptionally highvolatility is a suresign the trendcannot continue
Top confirmed
Top really confirmed
Targetfrom firstconfirmationTargetfrom secondconfirmation
FIGURE 11.5
Natural gas shows a classic triple top. Triple tops can contain otherpatterns. In this chart, the first peak is an island reversal and the second is a spike. The thirdpeak fails to reach the highest price, making it easier for traders to sell.
Top and Bottom Formations
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THE DANGER OF TRADING DOUBLE AND TRIPLE TOPSWe can find many examples of double tops and a fair number of triple tops.There is a lot of money to be made by selling these tops at the right place.Before you start planning your next coup, think about why a triple top isso rare. It’s because prices continue higher and the potential triple top disappears into a strong bull market pattern. You need to be very selectiveabout trading tops. Few of them actually become tops when you look back atthe chart.
TARGETING PROFITS AFTER TOPS AND BOTTOMSWe’re going to use volatility to decide when to take profits. Volatility is considered reasonably stable by traders because it seems to increase slowly anddecrease slowly. It can remain at the same level for extended periods. Whenprices are running up sharply, we expect volatility to continue to increaseuntil the top is formed. That gives us a tool to target a retracement price and,in turn, tells us when to take profits and exit the trade.Figure 11.5, natural gas, is a perfect example of a volatile top formation thatoffers a trading opportunity. The first pullpack after the island reversal broughtprices to $8.20, followed by the a test of the top that formed the second peak.If we had tried to sell the test of the first peak, we would have seen prices goslightly higher and most likely we would have stopped out the trade.The second retracement was only to $9.00, followed by another run up.We won’t try to sell the highs because the risk is too great and the last time wewould have been forced out. Instead, we sell when the high fails and the pricemoves below the first retracement low of $8.20. The break of $8.20 is calledconfirming the top. It creates a final triple top formation. We could havepicked the price of $9.00 as a selling point if you are an aggressive trader, butprices could still be jumping around. When it drops from $9.00 to $8.00, youcan be sure that prices aren’t going to make another test of the highs.
Calculating the Profit TargetWe find the profit target by measuring the height of the top formation andprojecting it downward from the point marking the end of that pattern, thelevels where the top is confirmed. In Figure 11.5 there are two confirmations,the first at $9.00 and the second at $8.20. If we mark the top at $10.75, wehave two volatility values, $1.75 and $2.65, the differences between the topand the confirmation levels.
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We can now find the profit targets by subtracting the volatility from theconfirmation levels. For the first trade we get $9.00 − $1.75 = $7.25, and forthe second $8.20 − $2.65 = $5.55.The first target is realistic. Prices are very volatile and a drop of $1.75could occur very quickly. The second target is less realistic, although pricesget to that level after stalling at about $6.50. When targeting a much largerdecline, and beginning at a much lower point, it is unrealistic to expectvolatility to continue at the same high level. In the decline of natural gas fromJanuary through March, we can see that volatility also drops.When targeting a price that is half the starting point (from $10.75 to$5.55), you must expect volatility to decline. A good estimate is to expectvolatility to halve because our second target would be a decline to half thetop price, we need to reduce our target by 25 percent (the average declineover the period). That gives us a conservative goal of $6.85, which fallsright in the middle of the sideways range that begins in mid-February.Adjusting for volatility is simply an attempt to be realistic. It’s best to beright more often and not try to squeeze every penny out of a trade.
Profit Targets after a Bottom FormationWe apply the same principle to calculate the profit target for bottom formations. We measure the distance from the bottom to the confirmation pointand then project that value upward from the confirmation price. If we goback to Figure 11.4, the double bottom in Cisco spanned the price range fromabout $5.00 to $6.25. We project the volatility of $1.25 up from the breakoutat $6.25 to get the target of $7.50. Because volatility should expand as pricesrise, we can use the exact volatility calculation as a conservative measure.
ROUNDED TOPS AND BOTTOMSWhen prices change direction over a longer time period, they can create arounded top or bottom pattern. A rounded top reflects a gradual change inmarket forces from buyers to sellers. It is a very clear sign that any attemptto move prices higher has been abandoned. Rounded tops often lead to fasterand faster price drops as more investors liquidate or initiate shorts.In Figure 11.6 we see two classic rounded tops in the German DAX stockindex. The first is an example of gathering downside momentum as moreinvestors become aware of the decline. Prices drop faster after a break of thedouble bottom.
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Top and Bottom Formations
Rounded top
Rounded topDouble bottom
Classic “V” bottom
FIGURE 11.6
Two rounded tops. It is unusual to see two rounded tops, one following theother, but this chart of the German DAX shows prices gradually turning from up to down, thenaccelerating to the downside. A rounded top is a strong sign of a weak market.
ROUNDED BOTTOMSA rounded bottom, similar to a rounded top, is an extended formation whereprices gradually turn from down to up. In Figure 11.7 we see a rounded bottom in the Japanese yen followed by a breakaway gap. Because rounded bottoms are a long formation, traders look for a breakout to signal a change inthe supply and demand balance. A breakout, whether in stocks or futures,indicates that something new has entered the picture.
Irregular Rounded BottomNot all rounded bottoms are perfect. Sometimes you need to look past afew odd spikes or gaps to see the bigger picture. In Figure 11.8 we can identify an irregular rounded bottom. The key to this formation is the way itemerges from the pattern beginning in mid-February 1992 until it accelerates at the beginning of April 1993. The extended bottom formation incrude oil, and the gradual change of direction, marks a shift in investor attitude. Once an upward breakout occurs, we do not expect to see these lowsagain for some time.
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Island topLarger island top
Breakaway gapRunaway gapRunaway gaps
Spike
Rounded bottom
Runaway gapsIsland bottom
FIGURE 11.7 A classic rounded bottom in the Japanese yen. This extended roundedbottom from late 1994 through early 1995 was followed by a breakaway gap, indicating achange in supply and demand. Some other classic chart patterns are marked.
Double top in crude oil
Rounded bottom
FIGURE 11.8 A somewhat irregular rounded bottom. Crude oil shows an irregular but roundedbottom. The key element is the gradual rise in prices at the end of the formation. Once prices breakout of this extended bottom, we don’t expect to see another test of the lows for some time.
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Top and Bottom Formations
WEDGE TOP AND BOTTOM PATTERNSWe have seen a wedge formation as a continuation pattern, but a largeascending wedge can mark the top of a move and a large descending wedgethe bottom. The dominant characteristic of the wedge is that volatility is declining toward the end. If we look ahead to Figure 11.10 we see a decliningwedge in the Japanese yen. Volatility compresses until a breakout is inevitable. There are no profit targets associated with the breakout of a wedge,but when it appears, it’s a good chance that a breakout is about to occur.
THE HEAD-AND-SHOULDERS FORMATIONThe most desirable and predictable of all top and bottom formations is thehead-and-shoulders. A head-and-shoulders top has three peaks, the leftshoulder, head, and right shoulder, where the head is higher than the shoulders (see Figure 11.9). The low points between the left shoulder and the head,and the head and right shoulder, form the neckline. The neckline is the sup-
Leftshoulder
HeadRising right shoulder
Neckline
Sell
Test of neckline failsTarget using bottomformation volatilitySimilar level for new resistance
Target
Simple breakout
Rising double bottom
FIGURE 11.9 Head-and-shoulders top pattern. A classic head-and-shoulders top is seen inthe Japanese Nikkei. The height of the top is projected from the breakout of the neckline to get theprofit objective. Another bottom formation, although not a head-and-shoulders, is treated in thesame way, projecting a target from the confirmation point of the bottom pattern using volatility.
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port line for the head-and-shoulders top. When prices break the neckline weexpect a continued drop.
Head-and-Shoulders Profit TargetIn exactly the same way that we have calculated profit targets for other topand bottom patterns, we find the target for head-and-shoulders top by measuring the volatility of the pattern and reflecting it down from the break ofthe neckline. In Figure 11.9, the peak of the Japanese Nikkei index was atabout 22,750, above the neckline by 2,750 points. If we project the same 2,750below the neckline at the point of the breakout (20,250), we get a price objective of 17,500, right at the lows of the first decline. We could have reduced ourtarget because we expected volatility to decline as prices dropped, assuringus that prices would reach our target.
Head-and-Shoulders BottomA head-and-shoulders bottom is an upside down version of the top. It is notas common and not as exciting to trade as the top formation, although it alsois dependable. Profit targets are calculated in the same way, measuring thedistance from the bottom of the head to the neckline, and then projecting thatdistance above the neckline from the point of the breakout.
Skewed Head-and-Shoulders TopAs we’ve come to realize, chart patterns are not always as clear as the classic versions, and it is necessary to recognize some of the variations in orderto increase your trading opportunities. In Figure 11.10 we have a skewedhead-and-shoulders top. The left shoulder and head begin in the classic way,but the right shoulder is wider than we would expect. The entire pattern isslanted up far more than the previous example, as you can see when theneckline is drawn. It is not until after the third attempt at highs on the rightshoulder that prices break through the neckline. After that, prices behavewell, moving quickly to the price objective.
A Clear Bottom, but Not an Identifiable PatternRather than keep a checklist or a template of patterns to match against eachchart, you must learn to see a bottom or top formation in many differentshapes. Figure 11.9 has a clear bottom at the end of 1998. Prices make a low
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Top and Bottom Formations
HeadLeftshoulder
Right shoulderNecklineSellsignal
Target
Buy signalDeclining wedgebottom
Head and shoulderstarget is the distancefrom the top of headto the neckline, droppedfrom the point where theneckline is broken
FIGURE 11.10
A skewed head-and-shoulders top and a declining wedge bottom.Not all head-and-shoulders patterns develop in the same way. This one has an extended rightshoulder and a steep upward neckline. Once the breakout of the neckline occurs, prices act inthe normal way, reaching the price objective quickly. The declining wedge formation is also areliable pattern for expecting a change of direction.
at the beginning of October, rally, and then test the lows in January. The bottom is confirmed when prices cross above the high formed between the twolows, and then move up to a price objective measured from the volatility ofthe confirmed bottom pattern.We apply the same principles for all top and bottom formations. We waituntil there is a breakout of the formation, and then we expect prices to moveat least a distance equal to the volatility of the top or bottom pattern. For ahead-and-shoulders formation, a double bottom, a rounded bottom, or anycombination, the principle is the same.
TRADING GAME TIPSRisk versus reward. By now you should have a worksheet with quite a fewtrades. Look at the average profit and the average loss. There should be oneof two patterns:
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1. You have more losses than profits, but your profits are bigger than your
losses.2. You have more profits than losses, and your losses are bigger than your
profits.Either pattern is good if you come out with a net profit. If you’re a trendfollower, you’ll have more small losses. A good ratio of the size of profits tothe size of losses is 2.5. If you’re an active trader, or scalper, then you’ll takeprofits often but allow more risk. That ratio could be .75. If you have this pattern but are not profitable, your ratio isn’t right. Your profits need to be a little bigger, or your losses a little smaller. If you target profits that are tooclose, then the commissions eat into your profits and you end up behind.If you don’t have either pattern, take another look at your trading style.Don’t shift between taking profits quickly and then holding for the big trendmove. Stay with one style.Don’t use a limit order to protect risk. A limit order is used to get a goodprice by buying on a decline. If you want to get out because prices are goingthe wrong way, close out the trade right away. Don’t fool with the order. Thefirst one out is the best.Don’t put your stop too close. If your stock trades in a $3 range each day,put your stop a minimum of $4.5 to $6 away from the market. You don’t wantto get stopped out the same day just because of market noise.
Questions1. True or false? It is best to sell a “V” top on the day it makes its spike at the
top of the move.2. Define an island top.3. Which is riskier to trade, (a) selling a double top or (b) buying a double
bottom?4. The price of a stock falls through support at $30, and then forms a double
bottom with a low of $21. After better economic news, prices rally andbreak through resistance at $30. You buy. What is your price objective?5. If the volatility of a double top was $10 and prices moved through sup-
port at $40, the point where the double top was confirmed, what wouldbe your maximum profit target? What would be a more realistic targetand why?6. Describe the classic calculation for a head-and-shoulders top profit target.
C H A P T E R 12
Retracements,Reversals,Fibonacci Numbers,and Gann
rice movement is a combination of two steps forward and one backward. The more serious students of price patterns say that it movestwo steps forward and 1.618 steps backward. Whoever is right, pricesrarely move in one direction without reversing.Anticipating the size of a retracement is an attempt to capitalize on themass behavior of the investors. The continuous flows of funds in and out ofthe markets are not at random points, but reflect the risk tolerance of eachparticipant. When seen as the action of a large group, the places where pricesstop and reverse, in both their forward movement and backward steps, seemto cluster at specific levels.We will look at the most popular ways to measure the ebb and flow ofprices beginning with the simplest and moving to the esoteric. The methodyou choose to use can be at either end of the list, or anywhere in between.Accept and use only what you think is reasonable.Retracements are most important after a sustained price move or duringa clear trend. It is necessary to gain the support of the investing masses inorder to expect consistent patterns.
P
PERCENTAGE RETRACEMENTSThe most important reversal that follows a sustained trend is a retracementof 100 percent—prices give back all of their gains. A 100 percent pullbackmeans that the reason for the previous trend has disappeared. This is mostcommon for shorter moves, where prices are driven by a single news event
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that turns out to be false. It happens often and can produce a large priceswing, but lasts only a few days.False news can be quite common. The government revises its previousGDP numbers each time it releases new ones. Each year the media report amajor problem with crops, the result of too little rain or too much rain. In theend technology wins, and there is a record harvest. There are constantrumors of large companies being the target of a Securities and ExchangeCommission (SEC) probe, or they are about to announce the correction of anaccounting irregularity. When the news turns out to be false, the market simply returns to the price level before the news.For seasonal commodities, such as crops, there are longer patterns of rising and falling prices. In 1988, a shortfall in the soybean crop with dwindlingwarehoused stocks caused prices to double (see Figure 12.1). After two yearsof good harvests, inventories were restored and prices returned to originallevels, a 100 percent retracement.In 2001, a typical seasonal pattern in soybeans (see Figure 12.2) shows arally during the growing months, June through August, based on lack of rain.By the end of August prices stopped going up when traders realized that the
Classic seasonal rally in soybeans(June–July growing season)followed by a steady declinein anticipation of a larger cropin the following year
100% retracement
FIGURE 12.1
Classic soybean supply problem. A poor crop in 1988 limits supply anddrives prices higher. It took two years of good harvests to restore the inventory of soybeans andreturn prices to previous levels.
Retracements, Reversals, Fibonacci Numbers, and Gann
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FIGURE 12.2
A 100 percent retracement in soybeans during 2001. Typical seasonalityturns concerns about the weather into price uncertainty. Soybean prices rally during the growingseason, from June through August, when the outcome of the crop is still unknown. By the endof August there is a good estimate on the final size of the crop, and prices drop back to normallevels. This 100 percemt retracement shows there was no problem in the end.
weather problems affected only a small part of the crop, but a large amountof news coverage on CNN and CNBC. As harvest begins, and the crop sizelooks normal, prices fall back to the same level as in the spring, another 100percent retracement.We will look at other examples of soybean prices because for many yearsthey were the most actively traded market. Farmers, grain elevators, andspeculators have been doing the same thing since the mid-1800s and there aremany examples in soybean patterns. Many patterns used to analyze stockand index prices come from agricultural futures markets. Traders adopt anytechnique that works. The much greater liquidity of soybean futures compared to individual stocks during the middle of the 1900s makes the futurespatterns clearer.
Other Percentage RetracementsThere is a significant difference between a 100 percent retracement and apartial retracement. A full retracement says that the previous rally was
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based on bad information. But what does a 50 percent retracement say? Thatthe information was half right?Retracements are a common occurrence in a trend. They have been compared to the ebb and flow of a tide. Investors buy until they have bought toomuch, and then the sellers come in to correct the overbought situation untilthe price is back to a level that attracts more investors. The history of technical analysis is full of well-known traders who have concluded that there isa profitable pattern in the retracements. Among these, Schabacker favored aone-half or one-third pullbacks; anything larger was considered a trend reversal. Gann, whom we discuss later, chose inverse powers of 2, giving 1⁄2, 1⁄4, 1⁄8,and so on as his key levels. Angus considered 1⁄4 as the most important. Dunnigan and Tubbs liked 1⁄3, 2⁄3, and 3⁄4. Elliott advocated the Fibonacci ratios of.618 and .382.The obvious problem is that if we use all of these retracement levels, theprice is bound to stop at one of them. How can you trade that? If you staywith the principle that the most basic retracements are the most likely to beimportant, then you’ll always be safe. Then 100 percent is the most important,and 50 percent is the next in line. After that we have 1⁄3 and 1⁄4, each of lessimportance. Certainly 1⁄8 is too small to consider. The exceptions are the
62% rallyback to highsTwice thelast rally25% rallyoff support50%retracement
50% retracementlow of move topeak
82% retracement of move fromlow to peak2/ retracement3
from peak
1/ retracement3
from start of rally
FIGURE 12.3
Retracements for soybeans. A weekly chart shows the bigger picture ofretracements for soybeans. Most of the popular retracement percentages can be found easily.
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Peak2(exactly twice peak 1)
Peak 1
50% line38% line
25% line
62% retracement
Starting level
100% retracements
FIGURE 12.4
Soybean retracements in the late 1970s. Are the lines significant, or arethere so many that one is likely to be at the place where prices stop and reverse?
Fibonacci ratios, which we discuss separately in this chapter. There seems tobe good support for expecting mass behavior to be reflected in the Fibonacciratios.Including Fibonacci, the most important retracements are 100 percent,50 percent, and 61.8 percent. Figures 12.3 and 12.4 show various retracements measured on two periods of soybeans. Markets that have high volumeare most likely to conform to standard retracements. That means index markets, such as the S&P 500, would also show 50 percent and 61.8 percent pullbacks, but individual stocks may not. Mass behavior is a function of broaderparticipation and a big picture of economic price movement.
S&P Retracement LevelsThe S&P has very high trading volume; therefore, we would expect retracement levels to conform to the rule of large numbers. In Figure 12.5, the swinghighs and lows are marked with letters beginning with A and C at the top,with B the low between them. From there we see that a drop to D is a decline of100 percent of the range from A to B, followed by a retracement of 50 percentback to E (support becomes resistance). Throughout the decline we can find
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A
C
100% retracement from A-B
E
50% retracement of C-D
BG50% of E-F
DI62% of G-H
F50% of G-H38% of G-H
H
FIGURE 12.5
S&P retracement levels. Highs and lows are shown with letters, and theobvious retracements are measured from combinations of highs and lows. The S&P shows areasonable number of 50 percent retracements.
numerous examples of retracement that conform to our expectations of 100percent, 50 percent, and less importantly, 62 percent.Each time we look for retracements, we need to ask ourselves, “How canwe trade it?” If we expect a rally to stop at a 50 percent retracement, we automatically sell at that price. However, what if prices continue to rally? Anticipating where a retracement will stop isn’t a good policy. If the price advanceslows down, volatility drops, and volume falls, all at a point very close to yourexpected retracement level, then you can sell. If a new high follows on anincrease in volume, then you get out and try again later. Common sense isneeded, in addition to a retracement target.
TRADING AT EVEN NUMBERSIt is said that prices advance and decline to even numbers. A stock is morelikely to stall at $10 than at $9.25; the price of gold resists moving below$300, but once it has traded lower, it struggles to go back above $300, andthen slows at $310 and $320. A study by the New York Federal Reserve confirms the increase in trader activity around even numbers.
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It makes sense that investors are more likely to place orders at an evennumbers. We simply don’t tell a broker to buy at $12.375 but would morelikely buy at $12.25 or $12.50. Even more investors would choose $12.00 or$13.00. When Martha Stewart placed her well-known order to sell Imclonestock, it was at $60, not at some odd value.A good trader can take advantage of this obvious bias for placing ordersby avoiding even numbers and looking for free exposure when prices movethrough those levels. Think of them as mini-breakouts. If you want to sell abreakout of Imclone at $60, place your sell order at $60.25 and be ahead ofthe crowd.
FIBONACCI AND HUMAN BEHAVIORFibonacci (Leonardo Pisano) observed nature and reproduction to create hisfamous Fibonacci summation series. We will discuss the basis for this seriesand some of its features in order to give you a better understanding of why ithas been broadly acceptedThe process is said to begin with two rabbits (1,1) who then reproduce(added together) to get 2, giving the starting series of 1, 1, 2. The last twonumbers are added to get 3, then 5, and so on, until the final series is: 1, 1, 2,3, 5, 8, 13, 21, 34, 55, 89, 144, . . . .There are two remarkable aspects of this series:1. These numbers occur with surprising frequency in nature.2. The ratios of the adjacent numbers in the series are unique.
You will find Fibonacci ratios used throughout technical analysis, and youwill find them throughout nature and art.
Fibonacci RatiosThe most important facts to remember about Fibonacci ratios are:• The ratio of one number in the series to the following number, N / (N + 1),approaches .618.• The ratio of one number to the previous number, (N + 1) / N, approaches1.618.• Multiplying the first two ratios together gives the value 1.0.• Pythagoras, the famous mathematician, left behind a triangle withFibonacci proportions and the words “The Secret of the Universe.”
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Fibonacci in NatureThere are countless occurrences of the numbers 3, 5, 8, 13, and 21, as well ascombinations of those numbers occurring in our life. A few common ones are:• The human body has 5 major projections, both arms and legs have 3 sections, there are 5 fingers and toes, each (mostly) with 3 sections, andthere are 5 senses.• In music, an octave means eight, with 8 white keys and 5 black, totaling 13.• There are 3 primary colors.• The United States has 13 original states, and 13 is an unlucky number.• The legal age is 21, and the highest salute in the army is 21 guns.• According to the Kondratieff wave, the business cycle is 55 years.• The normal sunflower has 89 curves, 55 in one direction and 34 inanother.• The genealogical pattern of the beehive and the leaf pattern of thesneezewort are perfect representations of Fibonacci numbers.• The chambered nautilus is a perfect Fibonacci golden spiral (all measures are Fibonacci ratios).
Fibonacci in ArtOccurrences of Fibonacci ratios in art may be more important than those innature because they reflect human behavior and perception. It is said thatFibonacci may have created his series after observing ancient structures.• The Great Pyramid of Giza has 5 surfaces, 8 edges, for a total of 13. Thereare 3 edges visible from any side. It is 5,813 inches tall (5-8-13), and theinch is the standard Egyptian unit of measure; the ratio of the elevationto the base is .618.• The Parthenon, sculpture of Phydias, and classic Greek vases are allmade to Fibonacci ratios. Leonardo da Vinci used them extensively.
Fibonacci in BehaviorIn documented tests, when asked to pick a number between 0 and 100, theresults of a large sample number clustered around 0, 38, 50, 62, and 100. Thisappears to be a natural response.
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Fibonacci and Price RetracementsWhy all this bother about Fibonacci numbers? It is because, when we lookback at the retracements in Figures 12.3, 12.4, and 12.5, we can see numerous examples of 62 percent and 38 percent retracements. You can find moreif you study the charts carefully. Most importantly, traders watch for thosenumbers. Perhaps it’s self-fulfilling, but we care only that retracements stopat 62 percent more often than you would expect. R.N. Elliott, creator of theElliott Wave Theory, relied heavily on Fibonacci ratios.
FIBONACCI TIME TARGETSWhile we’re discussing Fibonacci ratios, there is another way to use thesevalues to target price movement. Instead of projecting a price target, we canproject the time when the target will occur, that is, the date when prices willturn from an uptrend to a downtrend.
C
H = (G − F) × .618
A
F = (“4” − “3”) × .618
B
H
G
E = (D − C) × .618
F
E
D = (C − A) × .618
D1
4
“1” = (B − A) × .30
3“2” = (C − A) × .382
“5” = (H − C) × .382