.
would see a downward spike. Don’t act too quickly to accept a spike as a topor bottom. Even as a fast trader, buying on either day would have produceda large loss. You are safer if you treat them as if they will disappear, whichhappens much more often.
ISLAND REVERSALAn island reversal, or an island top, is a single price bar, or group of bars, sitting at the top of a price move and isolated by a gap on both sides, before andafter the island formation. Combined with high volatility, this formation hasthe reputation of being a major turning point. The gap on the right side of theisland top can be considered an exhaustion gap.You can find quite a few island tops in the Euro chart (see Figure 9.4),although most of them are at different stages during the strong trends. Islandtops can disappear into the overall chart pattern along with other formationseven though they are very good at defining a local top. Look at January 2001,just to the right of the highest point on the chart, and you can see an island
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Island top
Serious downtrendGood uptrendGood uptrend
FIGURE 9.5
Heating oil shows an extreme island reversal. Although this pattern did notremain a top for long, it was an exciting moment in time.
top of two bars. In March 2001 there is another island top of eight barsformed as prices decline. There is an island bottom near the beginning of thechart, in October 2000, that is the low point of the chart.Even the most extreme-looking island reversals may not remain the topfor long. In August 1991 heating oil jumped 6¢ in one day (see Figure 9.5),stopped, and then reversed. It may look strange on the chart when we see itin context with later trading, but it was an exciting moment at the time.
REVERSAL DAYA day in which there is a new high followed by a lower close is a downwardreversal day. An upward reversal day is a new low followed by a higherclose. Reversal days are a common part of technical conversation and appearto be an important sign of a change of direction. It is very likely that a reversal day will start a change of direction after a sustained trend up, or a movethat peaks on high volatility.The rapid drop of Tyco in January 2002 (see Figure 9.6) shows that areversal day occurred at the top just before the final fall. During the decline
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Reversal day(down)
Reversal day(upwards)
Reversal day(upwards)Not a reversal day
Reversal day(upwards)
FIGURE 9.6
Reversal days. Upward and downward reversal days can be seen during theprecipitous decline of Tyco. Reversal days are valuable when used selectively.
there were three upward reversal days, each followed by at least one higherday—no small accomplishment in a stock that is in a free fall. If a stock istrading on new lows for the current move and, then closes higher on the day,the selling pressure must be exhausted. We shouldn’t be surprised to see thestock trade higher the next day. After all, prices don’t go down or up everyday without reprieve. There are always buyers and sellers.
Perception and RealityThe problem with a reversal day is that it is a very short term indicator. Itdoes not tell you that the major trend has changed, only that the next day islikely to trade in the opposite direction.Another important problem with reversal days is that we only look forthem during special situations, particularly when prices are volatile or whenwe are near what we think is the top or bottom of a move. Reversal days happen often when we’re not looking. If you study the reliability of reversal days,you would find that they have no special predictive qualities—no one has
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proved that they are profitable on balance. Yet, experienced traders knowthat they are important.Limit your use of reversal days to special situations, those days when youare looking for prices to change direction. Then, only expect the next day toreverse. If prices fail to continue their new direction or show a tendency to reverse again, get out. A reversal day cannot win over the major trend; it canonly signal a short pause.
THRUST DAYS AND RUN DAYSAn upthrust day is one in which the close is higher than the previous day’shigh. A run day is a more powerful version of a thrust day and it must havetwo qualities; (1) The high must be greater than the high of the past N days,and (2) the low must be lower than the low of the subsequent N days. Therefore, a run day is not known until N days after it has occurred. The importance of a run day depends upon N. The larger the value of N, the moreimportant the run day.
Selecting the Important Thrust DaysA thrust day is a good concept for distinguishing a weak or strong move up(or down). Consider that the volume of trading varies across the day, andthere can be very low volume through the middle of the trading day. A newhigh or low that occurs on a moderate-size order during a low-volume timecould temporarily push prices to new highs or lows, breaking through a resistance or support level. If the price closes back inside the lines, perhaps evenunchanged on the day, we would be suspicious that the breakout was false.If instead prices closed outside the previous range, above the resistance line,we would be confident that something new was happening. Therefore, athrust day that also breaks a trendline or moves outside a range is important.It may be unimportant at other times.
Are Run Days Useful At All?There are many chart patterns that confirm the trend. That is, they assure youthe trend is still intact and you can hold your position. The jury is still out onrun days. Although they are a well-recognized price pattern, they are not“timely”; that is, it is often too late by the time you can identify the pattern.
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5 day up run day5 day up run day
5 day up run day
5 day run day
FIGURE 9.7
Run days. A 5-day run day is recognized when the high is greater than the highof the previous 5 days and the low is lower than the low of the following 5 days. Both thrustdays and run days provide evidence of a trending market, although run days may not be timely.
In Figure 9.7 we see eight cases of a five-day run day. We use five-days tobe more selective and to expect greater reliability. Don’t forget that we canrecognize this five-day run pattern only after it occurs. In the first case, thefifth day following the run day is a sharp move up, followed by a sharp reversal, and then a renewal of the upward trend. In each case shown, except forthe last three, the fifth day following the run day seems to be a local high.After that, price dropped off for a few days before recovering and continuingthe trend.
When to Use the Run Day PatternRun days suffer from the same problem as other chart patterns—they are lessdependable when fewer days are used. In this case, when you use more daysto recognize a run day, you may have waited too long for it to be a useful trading rule. A five-day run needs 10 days before it is identified. In the Tyco chart(Figure 9.7) the trend continued, if erratically, after the run days, but towardthe end of the chart they correspond to where the trend was exhausted. A run
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day may be helpful for confirming a trend after the fact, but there are betterpatterns for trading.
WIDE-RANGING DAYS, OUTSIDE DAYS, AND INSIDE DAYSBoth wide-ranging days and outside days are typical of higher volatility. Awide-ranging day is a day of much higher volatility than recent days. An outside day must have both a higher high and lower low than the previous day.Examples of wide-ranging days and outside days can be seen in Figure 9.8.
Wide-Ranging DaysA wide-ranging day is likely to be the result of a price shock, some unexpected news, or a breakout in which many orders are piggybacked, causinga large increase in volatility. A wide-ranging day could turn out to be a spikeor an island reversal. Because very high volatility can’t be sustained, we canexpect that a wide-ranging day will be followed by some type of reversal,even a one-day pause. When a wide-ranging day occurs, the direction of the
Inside days
Inside daysWide-ranging day
Outsideday
Wide-rangingdayWiderangingdayOutsideday
Widerangingday
Wide-ranging day
FIGURE 9.8 Wide-ranging days, outside days, and inside days. From October 1999 toJune 2000, Tyco shows a variety of daily patterns.
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close (if the close is near the high or low) is a strong indication of the continued direction.
Outside DaysAn outside day often precedes a reversal. An outside day can also be a wideranging day if the volatility is high, but when volatility is low, it provides aweak signal. As with so many other chart patterns, if one day has a tiny trading range, followed by an outside day of normal volatility, there is very littleinformation in the pattern. Selection is important.
Inside DaysAn inside day is one where the high is lower than the previous high and thelow is higher than the previous low. That is, an inside day is one where boththe highs and lows are inside the previous day’s trading range.An inside day represents consolidation, or lower volatility. In turn, lowervolatility is most often associated with the end of a price move. After a burstof activity and a surge of upward direction, prices have reached a point atwhich the buyers are already in and the price has moved too far to attractmore buyers. Volume drops, volatility drops, and we see an inside day.Very often, an inside day is followed by a change of direction, but that isnot guaranteed. We only know that the event that drove prices up is nowover. If more news surfaces to ignite prices, the next more could just as easily be up.Figure 9.8 shows two inside days at the price peak on the top left of thechart. The first inside day is followed by a small move lower, then a smallmove higher, and then by another inside day. This last inside day precedes amajor sell-off. On the right top of the chart there are two inside days immediately before another sharp drop. So far, this looks good.Take a few minutes to look at the chart more carefully. There are at least20 other inside days. Try to decide whether these other patterns are as reliable. We again face the issue of selection. Can we ignore certain inside days,yet quickly identify others so that we can trade? Is an inside day more reliableafter a price move of 3 percent, or 5 percent?
A COMMON MESSAGE ABOUT ONE-DAY PATTERNSBecause these chart patterns are based on the events of a single day, theyoccur often. High frequency tends to make a pattern less reliable and less
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profitable. You cannot expect to profit from a one-day pattern unless you areselective about the situations that apply best.During a quiet, sideways period of price activity, none of these patternswill be useful. When prices have moved quickly and volatility has increased,we look for a sign that the move is over. That allows us to take profits on thetrade and, if you’re an active trader, reverse your position. At those times,many of the one-day patterns, such as a key reversal or an inside day, will behighly reliable.
FEEDBACK PROCESSChart patterns confirm the trend, and yet the trend creates the chart patterns. It’s a feedback process. Although many patterns are based on the waypeople trade, some patterns are the result of expectation. If you see a highlyvolatile up day, especially a reversal day where prices close lower, tradersexpect prices to change direction the next day. Therefore, they are encouraged to sell.The recognition of patterns and the expectation of results make it difficult to decide whether all these patterns are true because of the way peopletrade, or because traders believe they are true. Does it matter?
TRADING GAMEBuy the rumor, sell the fact (anticipation vs. reality). XOM was tradinghigher than the market and then announced higher than expected profitsfrom the merger of Exxon and Mobil (a year earlier). The market moves onanticipation. Once the news is out, everyone knows what should be done.The reality of downgrading a stock. Any brokerage house, such asGoldman Sachs, announces a downgrade only after it has already liquidatedthe positions for its own clients. They would be foolish to tell everyone elsefirst and then compete with them for a good price. That makes it a goodopportunity to do the opposite—buy after others have sold. The advance liquidation plus those who get out because of the downgrade force the pricedown to unreasonably low levels (at least in the short term).Money moves all markets the same way. During times when there is nospecial news about one of the stocks in the S&P, that stock price moves withthe S&P. The use of futures and trusts (such as Spyders, SPY) allows tradersto buy and sell the entire index of S&P stocks at one time. When that indexgoes out of line with the weighted average of the individual stocks compris-
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ing the S&P, program traders step in to correct that difference using arbitrage. This causes all stocks in the S&P to move together. Because of directtrading of the S&P Index as well a program trading, an individual stock mayturn from up to down at the same resistance level seen on the S&P chart.
Questions1. Define an upward gap.2. When is a gap most likely to occur?3. Name four gaps most often found on a chart. Briefly explain how to rec-
ognize each.4. If today’s price action is much more volatile than the previous month and
the high is much higher than the high of the same period, would we callthe pattern a spike or a wide-ranging day?5. Define an island reversal bottom.6. When are reversal patterns most reliable? (a) After a sustained move in
one direction, or (b) after a highly volatile move?7. Why would a five-day run day pattern be considered not timely for trad-
ing?8. After a sustained upward price move, there are two inside days. What
does this tell you?
C H A P T E R 10
ContinuationPatterns
rices have trending periods that can be traded profitably. Each trendmust have a beginning (where prices show a tendency to want to gohigher or lower), a continuous sustained period during which weclearly see the direction, and finally an end. These phases reflect the confidence of the investors and their behavior. Continuation patterns are a setof formations that appear during these phases and both reflect and confirmthe current stage of the trend. A continuation pattern occurs within along-term trend and is expected to be resolved by continuing in the direction the trend.
P
SYMMETRIC TRIANGLESTriangles are large formations that occur throughout a trend. At the beginning of a trend there is greater uncertainty and a symmetric triangle is mostlikely to appear. A symmetric triangle (see Figure 10.1) is formed by a priceconsolidation, that uncertainty results in decreasing volatility in a such waythat prices narrow to the center of the previous trading range. The breakoutfrom a symmetric triangle often marks the beginning of a longer-term trend.
DESCENDING AND ASCENDING TRIANGLESEven during a clear downward trend, prices will rally. Because the trend isclear, sellers are anxious to step in and sell these upward moves, looking for
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Symmetric triangle
Descending triangles
Descending triangles
FIGURE 10.1 Symmetric and descending triangles. These patterns, shown on a backadjusted price chart of gold futures, are formed as confidence in the trend direction increases.The symmetric triangle comes near the beginning of a trend, followed by more than onedescending triangle. These patterns are resolved in the trend direction.
the trend to continue. The top of the rally is likely to be the last support pointat which prices broke out of a previous pattern. The recent lows of the newtrend form a temporary support level, and prices may bounce off that levelwhile short-term traders play for small profits. This action forms a descending triangle. As more traders are convinced that prices are still heading lower,the rallies off support are sold sooner, causing a narrower pattern, untilprices finally break below support. The descending triangle is complete. Inan upward trend an ascending triangle would be formed.
Size of the TrianglesA triangle should take no less than two weeks to form; however, they canspan a much longer period. In the gold chart (see Figure 10.2) there are triangles of mostly two to three weeks, but the descending triangle in themiddle lasts three months. The descending triangle evolved as traders decidedthat gold was still in a downtrend.
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FIGURE 10.2
More triangles in a falling gold market. There are more triangles hiddenin the gold chart that is shown. These triangles can vary in size, some encompassing others.Because they reflect trader confidence and behavior, you must expect some inconsistencies.
After the large descending triangle was resolved, a symmetric triangleappears. Traders are again uncertain of the direction. Once resolved, pricesbegin a steep descent. We may have chosen to redraw the small descendingtriangle as a larger one to include the previous symmetric triangle. We alsomight find another descending triangle just before the last major drop inmid-February.Triangles can be very consistent indicators of investor confidence.Because they reflect human behavior, they are not always perfect in appearance and not always perfect in pattern.
FLAGSA flag is a smaller pattern than a triangle and is formed by a correction in abull market or a rally in a bear market. Flags are congestion areas that leanaway from the direction of the trend. At the beginning of a trend the flags andpennants may not lean away from the direction of the new trend formed by
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Flags lean away from the direction of the trend.They are formed with parallel lines.
Descending triangleSuspiciousflagTwo flagsSymmetric triangle
FIGURE 10.3 Upward flags in a downtrend. Flags are smaller formations than trianglesand are formed opposite to the trend direction. They can be as small as one week or as long astwo months.
two parallel lines, similar to a channel. If the first flag after an upward breakout leans down, it confirms the new upward trend.Figure 10.3 shows a series of three ascending flags, each larger than theprevious one, in a downward trend. In a downtrend, the most important partof the flag is the bottom line, or support line, because it must be watched fora break and a renewal of the downtrend. The top line that forms the flag canbe drawn parallel to the bottom line or across the peaks, if there is morethan one peak.
PENNANTS AND WEDGESPennants are irregular triangles normally leaning toward the trend, similar toa descending triangle in a downtrend. During a sustained trend, triangles arelarge, clear formations, and flags are frequent, smaller changes of directionwith parallel sides. Pennants are catch-alls. They are formations that occurduring the trend, but the lines converge rather than form parallel sides. Theyusually lean toward the trend, but that’s not a requirement. If it looks like aformation but you can’t quite identify it, call it a pennant.
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Symmetric triangle inside adescending triangle
FlagPennant
Symmetric triangleor a flag?
FlagTriangle orpennant?
FIGURE 10.4 An assortment of continuation patterns. All of these patterns are resolvedby prices moving lower. A pennant can be found in the middle of the chart.
In Figure 10.4 there is an assortment of continuation patterns applied toTreasury note futures, all resolved by a break down of prices. A small, classicpennant can be found in the center of the chart, pointing down. Following thepennant is a move up that could be interpreted as a large flag or a symmetrictriangle. If you don’t think that the triangle is exactly symmetric, you can callit a pennant.In the General Electric (GE) chart, Figure 10.5, there is a large pennant inthe middle. Pennants, just as other continuation patterns, represent a pausein a trend, followed by a consolidation. The way in which investors enter themarket, whether carefully or anxiously, ultimately will determine which continuation pattern is formed.
WEDGESIf the pattern looks as if it’s a large pennant but does not come to a point, thenwe can call it a wedge. In an upward trending market the wedge should berising. A strong upward wedge will have both lower and upper lines rising, as
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dge
g we
Risin
Rising wedgePennant
FIGURE 10.5
A strong rising wedge. The strong wedge formation has both the lower andupper lines rising, as seen in this chart of General Electric near the end of 1999.
shown in the center of the GE chart, Figure 10.5, near the end of 1999. The earlier wedge has a horizontal upper line, bridging the pattern between a wedgeand a rising triangle. In either case, investors are testing resistance and buyingsooner as prices drop. The result is a continuation of the upward trend.A typical rising wedge would have a lower line that is at a steeper anglethan the upper line, as seen in the GE chart, Figure 10.6. The earlier wedgeformation shown is nearly symmetric. If we study the bigger picture, we cansee that the uncertainty at the beginning of the trend is reflected in the symmetric formation. The rising wedge occurs after the trend is well establishedand investors can anticipate a continuation. The third, smaller pattern in Figure 10.6 may be treated as a wedge or a pennant.
CONTINUATION PATTERNS ARE NOT A SCIENCEIt is not important to be able to classify the pattern exactly, because not allpatterns are clear. It is very important to understand that a trend will createlarge patterns that lean in the direction of the trend and small correction
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FIGURE 10.6
Typical rising wedge. More often, a rising wedge shows a steeply risinglower line and a moderately declining upper line. You might also see this as a large pennant.The early wedge is more symmetric, indicating that the direction of price is not yet clear.
patterns that lean away from the trend. If the patterns take on a symmetricform or begin to lean in the wrong direction, the market is telling you that thetrend is weakening, or it is over.
TRADING TIPSDon’t avoid selling short. There is a lot of money to be made quickly asprices decline. Prices tend to drop faster than they rise. Being short GE andlong XOM could give you valuable diversification and greatly reduce yourrisk. Because they are part of the S&P index they may move together mostof the time, but you can profit from the spread, where GE is relativelyweaker than XOM.Be careful about using a single-spike low for your support level. A spikerepresents an extreme. A downside spike exists because a lot of traders camein and sold on the price drop. However, it’s a wide-ranging, extreme day, andthe bottom of that spike is an unreliable number. You might do best to ignore
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the spike for the purposes of support and resistance levels. There may behesitation as prices test the lows of the spike, but it’s not likely to stop thedecline.
Questions1. How does a continuation pattern help you trade?2. At what points in a trend is a symmetric triangle most likely to occur?3. Which triangle is most likely to occur in the middle of an upward trend,
a symmetric, ascending, or descending triangle?4. Describe a flag in an uptrend.5. What is the difference between a pennant and a triangle?6. During a downtrend, which way does a wedge point?7. What should you do if a descending triangle is formed during an uptrend?
C H A P T E R 11
Top and BottomFormations
he most elusive and unrealistic goal of trading is to buy at the bottomor sell at the top. Prices rarely stop where you expect. The only way tosee a top or bottom is after they occur. In this chapter we will look atthe most popular top and bottom formations and see which ones are the bestcandidates for trading, and when they can be used.We have already seen some of the top and bottom patterns, althoughthey may have occurred at different places in the price move. Spikes andreversal days, island reversals, and “V” tops and bottoms are simple formations. Rounded tops and bottoms and head-and-shoulders formations takelonger to develop but are very reliable.
T
“V” TOPSThe classic top is an inverted “V” although it is called a “V” top. It is asharp run up with a single day marking the high, and then an equally fastprice drop. It is always accompanied by high volatility and usually highvolume. The final peak may also be an upward spike. There is a classic “V”top in Amazon during January 1999, shown in Figure 11.1, and anotherpotential, smaller formation in April that looked as though it was a “V” toptwo days after, which quickly disappeared into a broader formation of noparticular pattern. You can’t tell a “V” top, after one day down. The finalpeak in late April 1999 is broader than a classic “V” top but may still gounder the same name.
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Potential“V” topClassic “V” topSpike
“V” Bottom
FIGURE 11.1 Classic “V” top in Amazon. The top in January 1999 is a classic “V” top;the highest top in late April is slightly broader, the result of a three-day price pattern. Justbefore the last top, in early April, was a potential “V” top that disappeared after three days.
The Blow-OffA “V” top with an extended spike at the top is thought of as a blow-off. Highvolatility, high volume, and a pattern of accelerating upward prices mustreach a point where the momentum can’t be sustained. The range on the lastday is wider than previous days, and the following day opens much lower andremains lower. The market thinks about whether it can muster enoughenergy to continue the run-up, decides that it cannot, and collapses. Everyone changes their opinion from bull to bear on the same day, and each wantsout before the others. Prices drop faster than they rose during the last part ofthe bull market.
“V” BOTTOMS“V” bottoms are much less common that their upside counterparts. Theyoccur more often in futures, where supply and demand can change dramat-
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Top and Bottom Formations
Island top
Secondary top
“V” bottom
“V” bottom
FIGURE 11.2
“V” bottoms in crude oil. Just as with “V” tops, a “V” bottom is the a clearstatement that prices have gone too far, too fast.
ically and leverage causes surges of buying and selling. Both “V” tops andbottoms should be read as a sign that prices have gone too far, too fast. Bothbuyers and sellers need time to reevaluate the fundamentals to decide whereprices should be. “V” bottoms are followed by a rebound and then a periodof sideways movement. Two good examples can be found in the crude oilchart (Figure 11.2).
DOUBLE TOPS AND BOTTOMSA double top is just what you would expect, one price peak followed a fewdays or weeks by another peak, stopping very close to the same level. A double bottom, more common than a double top, is the occurrence of two pricevalleys with the lowest prices at nearly the same level. Because prices aremore likely to settle for a while at a lower price than a high one, prices oftentest a previous support level, causing a double bottom.
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Double TopsTops and bottoms occur at the same level because traders believe that thesame reason prices failed to go higher the first time will be the reason theyfail the second time. At extreme tops and bottoms this is true. The very highor low prices are not supported by the fundamentals of the business or bythe supply and demand numbers. They are pushed to extremes by crowdpsychology without regard to reason. Traders, looking for a place to sell atan unreasonably high price, target the previous point where prices failed. Asprices move higher to test that level, increased speculative selling causes thebuyers to realize that something is wrong, and they back away from the market, causing prices to drop and forming a double top.Although a classic double top is thought to peak at exactly the sameprice, selling in anticipation of that test of the top may cause the secondpeak to be lower than the first. Figure 11.3 shows one type of double top incrude oil. Although some double tops are two sharp peaks, this one looks asthough it was gathering energy yet still failed to make new highs.
Rounded top in crude oil
No, it didn’t trade under zeroPrices have been roll-adjusted
FIGURE 11.3
A double top in crude oil. The double top, formed at the beginning of 1990,turned into a rounded top. Prices have been created by back-adjusting individual futurescontracts; therefore, the scale on the right doesn’t show the actual prices in 1990. The pattern,however, is identical.
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Double bottom confirmed
Double bottom
FIGURE 11.4 A double bottom in Cisco. In this double bottom pattern there are four failedattempts to move lower, followed by a faster break upward. When prices penetrate the highsbetween the two bottom patterns, we have a confirmation of the bottom. Our first profit targetwould be an equal distance above the confirmation, at about $7.50.
Double BottomsBottoms are more orderly than tops. They should be quiet rather thanvolatile. They are caused by prices reaching a level that is low enough for thenormal investor to recognize that there is little additional downside potential.Economists might call this the point of equilibrium. Neither buyers norsellers are convinced that prices will continue to move. They wait for further news.Double bottoms will often test the same price level because large position traders accumulate more stock, or increase their futures position, eachtime the price falls to their target level. Once prices are low, there is lesschance of absolute loss. Selling a double top can be very risky. The greatestrisk when buying a double bottom is that your timing is wrong. If prices don’trally soon, you’ve used your capital poorly.Cisco shows a double bottom in Figure 11.4, although it lacks the cleardecline in volatility that we would like to see. The small spikes down showfour attempts to go lower, followed by a faster move up. When prices cross
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above the highs formed between the two bottom patterns, we have a completion, or confirmation, of the double bottom.
TRIPLE TOPS AND BOTTOMSTriple tops and bottoms are considerably less common than double tops andbottoms, and much less likely to turn at exactly the same price. Figure 11.5shows a classic triple top in natural gas. There are many other patterns thatcomprise this top, including an island reversal as the first peak, a spike as thesecond, and finally a lower, wider peak that ends the move.If you look at the days following the first two peaks, each looked asthough it marked the top. After the first island reversal, prices dropped $2;after the second peak there was another large gap down and a one-day lossof more than $1. We can say only that investors were very nervous at $10.A triple bottom that can be traded is most likely to occur at low prices