Another price formation is the key reversal day. This minor pattern often warns of an impending change in trend. In an uptrend, prices usually open higher, then break sharply to the downside and close below the previous day’s closing price. (A bottom reversal day opens lower and closes higher.)
The wider the day’s range and the heavier the volume, the more significant the warning becomes and the more authority it carries. Outside reversal days (where the high and low of the current day’s range are both wider than the previous day’s range) are considered more potent.The key reversal day is a relatively minor pattern taken on its own merits, but can assume major importance if other technical factors suggest that an important change in trend is imminent (See Figure 7-1).
Gaps are simply areas on the bar chart where no trading has taken place.An upward gap occurs when the lowest price for one day is higher than the highest price of the preceding day. A downward gap means that the highest price for one day is lower than the lowest price of the preceding day.There are different types of gaps that appear at different stages of the trend. Being able to distinguish among them can provide useful and profitable market insights.Three types of gaps have forecasting value—breakaway, runaway and exhaustion gaps (See Figure 6-1).
The breakaway gap usually occurs upon completion of an important price pattern and signals a significant market move. A breakout above the neckline of a head and shoulders bottom, for example, often occurs on a breakaway gap.
The exhaustion gap occurs right at the end of the market move and represents a last gasp in the trend. Sometimes an exhaustion gap is followed within a few days by a breakaway gap in the other direction, leaving several days of price action isolated by two gaps. This market phenomenon is called the island reversal and usually signals an important market turn. The runaway gap usually occurs after the trend is well underway. It often appears about halfway through the move (which is why it is also called a measuring gap since it gives some indication of how much of the move is left.) During uptrends,the breakaway and runaway gaps usually provide support below the market on subsequent market dips; during downtrends, these two gaps act as resistance over the market on bounces.
O
ne of the more useful features of chart analysis is the presence of price patterns, which can be classified into different categories and which have predictive value.These patterns reveal the ongoing struggle between the forces of supply and demand, as seen in the relationship between the various support and resistance levels, and allow the chart reader to gauge which side is winning. Price patterns are broken down into two groups—reversal and continuation patterns. Reversal patterns usually indicate that a trend reversal is taking place. Continuation patterns usually represent temporary pauses in the existing trend.Continuation patterns
take less time to form than reversal patterns and usually result in resumption of the original trend.
REVERSAL PATTERNS
The Head and Shoulders
The head and shoulders is the best known and probably the most reliable of the reversal patterns.A head and shoulders top is characterized by three prominent market peaks.The middle
peak, or the head, is higher than the two surrounding peaks (the shoulders). A trendline (the neckline) is drawn below the two intervening reaction lows.A close below the neckline completes the pattern and signals an important market reversal (See Figure 5-1).
Price objectives or targets can be determined by measuring the shapes of the various price patterns.The measuring technique in a topping pattern is to measure the vertical distance from the top of the head to the neckline and to project the distance downward from the point where the neckline is broken.The head and shoulders bottom is the same as the top except that it is turned upside down.
Double and Triple Tops and Bottoms
Another one of the reversal patterns, the triple top or bottom, is a variation of the head and shoulders.The only difference is
that the three peaks or troughs in this pattern occur at about the same level. Triple tops or bottoms and the head and shoulders reversal pattern are interpreted in similar fashion and mean essentially the same thing.
Double tops and bottoms (also called M’s and W’s because of their shape) show two prominent peaks or troughs instead of three. A double top is identified by two prominent peaks. The inability of the second peak to move above the first peak is the first sign of weakness. When prices then decline and move under the middle trough, the double top is completed. The measuring technique for the double top is also based on
the height of the pattern. The height of the pattern is measured and projected downward from the point where the trough is broken. The double bottom is the mirror image of the top (See Figures 5-2 and 5-3).
Saucers and Spikes
These two patterns aren’t as common, but are seen enough to warrant discussion.The spike top (also called a V-reversal) pictures a sudden change in trend. What distinguishes the spike from the other reversal patterns is the absence of a transition period,which is sideways price action on the chart constituting topping or bottoming activity. This type of pattern marks a dramatic change in trend with little or no warning (See Figure 5-4).
The saucer, by contrast, reveals an unusually slow shift in trend.Most often seen at bottoms,the saucer pattern represents a slow and more gradual change in trend from down to up.The chart picture resembles a saucer or rounding bottom—hence its name (See Figure 5-5).
CONTINUATION PATTERNS
Triangles
Instead of warning of market reversals, continuation patterns are usually resolved in the direction of the original trend.Triangles are among the most reliable of the continuation patterns. There are three types of triangles that have forecasting value—symmetrical, ascending and descending triangles. Although these patterns sometimes mark price reversals, they usually just represent pauses in the prevailing trend. The symmetrical triangle (also called the coil) is distinguished by sideways activity with prices fluctuating between two converging trendlines.The upper line is declining and the lower line is rising. Such a pattern describes a situation where buying and selling pressure are in balance. Somewhere between the half-way and the three-quarters point in the pattern, measured in calendar time from the left of the pattern to the point where the two lines meet at the right (the apex), the pattern should be resolved by a breakout. In other words, prices will close beyond one of the two converging trendlines (See Figure 5-6).
The ascending triangle has a flat upper line and a rising lower line. Since buyers are more aggressive than sellers, this is usually a bullish pattern (See Figure 5-7). The descending triangle has a declining upper line and a flat lower line. Since sellers are more aggressive than buyers, this is usually a bearish pattern. The measuring technique for all three triangles is the same. Measure the height of the triangle at the widest point to the left of the pattern and measure that vertical distance from the point
where either trendline is broken. While the ascending and descending triangles have a built-in bias,the symmetrical triangle is inherently neutral. Since it is usually a continuation pattern,however, the symmetrical triangle does have forecasting value and implies that the prior trend will be resumed. Flags and Pennants These two short-term continuation patterns mark brief pauses, or resting periods, during dynamic market trends. Both are usually preceded by a steep price move (called the pole). In an uptrend, the steep advance pauses to catch its breath and moves sideways for two or three weeks.Then the uptrend continues on its way.The names aptly describe their appearance. The pennant is usually horizontal with two converging trend-
lines (like a small symmetrical triangle). The flag resembles a parallelogram that tends to slope against the trend. In an uptrend, therefore, the bull flag has a downward slope; in a downtrend, the bear flag slopes upward. Both patterns are said to “fly at half mast,”meaning that they often occur near the middle of the trend,marking the halfway point in the market move (See Figures 5-8 and 5-9).
In addition to price patterns, there are several other formations that show up on the price charts and that provide the chartist with valuable insights. Among those formations are price gaps, key reversal days, and percentage retracements.
There are two terms that define the peaks and troughs on the chart.A previous trough usually forms a support level. Support is a level below the market where buying pressure exceeds selling pressure and a decline is halted. Resistance is marked by a previous market peak. Resistance is a level above the market where selling pressure exceeds buying pressure and a rally is halted (See Figure 4-1).
Support and resistance levels reverse roles once they are decisively broken. That is to say, a broken support level under the market becomes a resistance level above the market. A broken resistance level over the market functions as support below the market.The more recently the support or resistance level has been formed,the more power it exerts on subsequent market action.This is because many of the trades that helped form those support and resistance levels have not been liquidated and are more likely to influence future trading decisions (See Figure 4-2).
The trendline is perhaps the simplest and most valuable tool available to the chartist.An up trendline is a straight line drawn up and to the right, connecting successive rising market bottoms. The line is drawn in such a way that all of the price action
is above the trendline.A down trendline is drawn down and to the right, connecting the successive declining market highs. The line is drawn in such a way that all of the price action is below the trendline. An up trendline, for example, is drawn when at least two rising reaction lows (or troughs) are visible. However, while it takes two points to draw a trendline, a third point is necessary to identify the line as a valid trend line. If prices in an uptrend dip back down to the trendline a third time and bounce off it, a valid up trendline is confirmed (See Figure 4-3).
Trendlines have two major uses.They allow identification of support and resistance levels that can be used, while a market is trending, to initiate new positions. As a rule, the longer a trendline has been in effect and the more times it has been tested, the more significant it becomes.The violation of a trendline is often the best warning of a change in trend.
Channel lines are straight lines that are drawn parallel to basic trendlines. A rising channel line would be drawn above the price action and parallel to the basic trendline (which is below the price action). A declining channel line would be drawn below the price action and parallel to the down trendline (which is above the price action).Markets often trend within these channels.When this is the case,the chartist can use that knowledge to great advantage by knowing in advance where support and resistance are likely to function (See Figure 4-4).
Price plotting is an extremely simple task. The daily bar chart has both a vertical and horizontal axis.The vertical axis (along the side of the chart) shows the price scale, while the horizontal axis (along the bottom of the chart) records calendar time. The first step in plotting a given day’s price data is to locate the correct calendar day. This is accomplished simply by looking at the calendar dates along the bottom of the chart. Plot the high, low, and closing (settlement) prices for the market. A vertical bar connects the high and low (the range).The closing price is recorded with a horizontal tic to the right of the bar. (Chartists mark the opening price with a tic to the left of the bar.) Each day simply move one step to the right. Volume is recorded with a vertical bar along the bottom of the chart (See Figure 3-1).
Charts Are Used Primarily to Monitor Trends
Two basic premises of chart analysis are that markets trend and that trends tend to persist. Trend analysis is really what chart analysis is all about.Trends are characterized by a series of peaks and troughs.An uptrend is a series of rising peaks and troughs. A downtrend shows descending peaks and troughs. Finally, trends are usually classified into three categories:major,
secondary, and minor.A major trend lasts more than a year; a secondary trend, from one to three months; and a minor trend, usually a couple of weeks or less.
