Chart Pattern Masters Series

Chart Patterns Master Series
Copyright 2008 Mark Deaton
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Table of Contents Introduction Megaphone or Broadening Bottom Megaphone or Broadening Top Cup and Handle Dead Cat Bounce Diamond Tops and Bottoms Double Tops and Bottoms Triple Tops and Bottoms Flags and Pennants Head and Shoulders Island Reversals Ascending Triangles Descending Triangles Ascending Wedges Descending Wedges Conclusion 2 3 6 9 12 15 18 22 25 28 31 34 37 40 43 46
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Introduction The theory of garnering profits through investments is easy to comprehend. Buy when prices are rising. Sell when they are falling. As everyone knows, however, prices just do not move steadily in one direction. They are volatile. The key to successful investing is, thus, being able to accurately determine whether the investment vehicle chosen for the time period in question will increase or decrease in price. Proper chart analysis is the methodology that will allow anyone to become a successful investor. For the astute investor, price charts are not just random movements depicted graphically. Proper recognition of the patterns that they form over time is the signals of where market participants are investing their money. If an investor can recognize these signals as they appear, it becomes a simple and self-evident exercise as to whether to buy (go long) or sell (go short) the investment under consideration. The price of a holding, whether it be the shares of IBM, crude oil, Japanese yen, or treasury bonds, will move based on the laws of supply and demand. When there are more buyers than sellers, the price will rise. When there are more sellers and buyers, the price falls. One classic investment methodology is called fundamental analysis. Basically, this technique attempts to look at all the factors that affect a particular investment under consideration, and based on an analysis of those factors, determine whether the likely demand for that investment will increase, stay steady, or fall. Once this analysis has been accomplished, the investor takes the appropriate position. In contrast to fundamental analysis are techniques referred to generally as technical analysis. The principles behind this methodology maintain that markets are in essence efficient, and they trend over time. This being the case, all the successful investor needs is to be able to recognize the repetitive patterns that develop in a chart in order to make proper investment decisions. Fundamental analysis becomes irrelevant because the price of an investment already reflects all the available information in the market. Whether an investor chooses to use technical analysis or fundamental analysis in his or her trading decision is a personal matter. It never hurts to be aware of all the tools available in making investment placements. Anyone familiar with markets knows chart patterns are actively used by the investment community. All brokerages supply investors with a plethora of information concerning charts to help their clients in making their decisions. Tens of thousands of analysts across the globe issue recommendations based on their interpretations of chart patterns. It would be foolish for any serious investor, no matter what type of market he or she is interested in, not to have knowledge of chart patterns and their importance to price movement. This book gives the reader the tools to identify the signals that chart patterns produce, with the goal of predicting with accuracy the direction of future price movement, the probable intensity of the direction, and the reliability of the movement. The information presented herein, when properly utilized, can greatly increase the wealth of any investor.
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Megaphone or Broadening Bottom A megaphone and broadening bottom formation on a price chart is generally regarded as a bullish signal. It signifies that the current downtrend is probably going to reverse itself, and then establish a new uptrend movement. This type of formation is characterized by successfully lower lows and higher highs which accumulate during an overall downward trend. For the proper formation to be recognized, there must be at least two higher highs situated between three lower lows. The chart pattern is considered complete when prices rise above the second higher high and do not return below it. This usually occurs during the third upswing during the formation of the pattern.
Source: http://www.marketscreen.com/help/chartpatterns/default.asp?hideHF=&Num=103 Performance Though considered a bullish formation, broadening bottoms that have downside breakouts can actually outperform those on the upside. Consequently, for the investor, this type of formation produces an opportunity both for a long and short position depending which way a breakout occurs. Statistical analyses of these types of formations tend to indicate that bullish breakouts will result in a significant move upwards from the point of breakout, as will downward breakouts on the downside. These formations appear to be remarkably accurate indicators, with some studies reporting as high as a 98% success rate of continued price appreciation when an upward breakout occurs. On the downside, the accuracy has been reported as high as 94%. Recognition
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In recognizing a broadening bottom formation, the two trend lines drawn across the intermediate highs and lows are very important. These trend lines should slope in opposite directions. In other words, the trend lines based on the intermittent highs should be rising upwards, and the one based on the lows should be headed downwards. This is the distinguishing aspect of a megaphone or broadening bottom chart pattern. Another one of the distinguishing aspects of this formation is that volume follows price. That is, between peaks and troughs, there should be a visibly declining volume of activity. The opposite should also hold true, from the intermediate lows to high. The point of entry when using such a formation as a signal should be a clear point above or below the trend lines that have been made. If prices clearly extend beyond or below the trend line, then that penetration point is the breakout point of the formation and represents the consideration price that needs to be exceeded for a position to be undertaken. The average time needed for the formation of this sort of chart pattern is about two months. It should be kept in consideration that this is the average, and the actual range can be significantly shorter or longer. The varying movements necessitated for the proper formation to occur require a significant amount of time to pass. Trading Considerations As these types of formations are so highly successful based on statistical regression analysis and their failure rate is so low, it is difficult to formulate a defensive strategy for those rare instances when they represent false signals. Generally speaking, however, if a breakout occurs in prices and then fails to move more than 5% in the desired direction before returning to the breakout point, positions should be liquidated. Megaphone bottoms that produce upside breakouts can be generally considered as reversals of the underlying downward trend. On the other hand, those that produce downside breakouts should be considered consolidations. This logically makes sense as these formations can only be recognized as such after a distinct previous downward trend has been identified. The failure rate of these formations is exceptionally low. If one is to give consideration as to how they are formed, this actually makes sense. Breakouts occur, as can be seen from any chart, at the widest point of the broadening formation. This means than an intermediate strong trend has already established itself on one side of the formation to the other. A large amount of momentum has actually been established, such that when a breakout occurs, prices are moving along in the direction of the least resistance. When trading a megaphone or broadening bottom formation, it is important to try to determine the likely price move that will occur once the formation is broken. Generally speaking, the best tactic to use is to subtract the lowest low from the highest high recorded during the formation of this chart sequence. This will give a measure of depth of range. This depth measure should be added to the highest high in order to obtain a target price after an upside breakout. Similarly, it should be subtracted from the lowest low for the short side target price upon a downside breakout. These target prices will always be approached when breakout occurs though they may
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not always be achieved; consequently, conservative investors may find it wise to have profitable exit points determined somewhat before the achievement of target prices. Regardless of what profit goals are established, every investor must be prepared for an unsuccessful trade. As a result, it is recommended to have a stop loss order placed at a level 20% below the minor low or high as has been exhibited in the formation. Using this strategy, the investor will only have a minor loss should a formation failure occur. For those aggressive traders, who want to hope that they have stumbled upon a major reversal or continuation pattern, they can continuously adjust their stops to the successive intermittent minor highs or lows that occur during the major move that they have discovered. Broadening bottom megaphone chart formations have been widely statistically analyzed by trading professionals. The results of these studies all indicate that these types of chart patterns can be exceptionally successful in predicting future movements, either on the upside or the downside. For the individual investor, these patterns, if they can be properly recognized, represents a remarkable tool for successful and profitable results in the investment markets. The data tends to suggest that the breakage of this formation is an exceptional signal for continued movement in the direction of the breakout, regardless of the type of market: stocks, foreign exchange, commodities, etc. As it is generally considered a rare occurrence, when it does happen, the knowledgeable investor will use it to his or her advantage.
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Megaphone or Broadening Tops Broadening or megaphone tops can be considered the opposite of broadening bottoms, and these formations signals act very much the same. What differentiates the top and bottom formations is the trend that has been established before the pattern arises. For megaphone tops, the price trend has been clearly upwards, while those for bottoms the opposite holds true. The directional differences are not the only distinction. These formations may act similarly, but their performance results differ. Statistical Evidence There are basically two types of broadening top chart patterns for the investor: one that produces an upside breakout, and the other which produces a downside breakout. As with broadening bottoms, statistically, these types of breakout signals can result in subsequent significant price movement in the direction of the breakout as high as 96% of the time, according to certain studies. Some research has demonstrated up side price movement averages as high as 34%, with down side breakouts averaging around 23%. Given these statistical results, these types of formations represent an exceptional tool for the investor in order to make investment decisions. Formation Characteristics There are many different recognized variations of these broadening formations. The characteristics of this general chart pattern are always the same. For a true megaphone top formation to exist, there must be a distinct precedent uptrend that can be seen in the chart. When trend lines connect the intermittent highs and lows, what results should be a visualization that resembles a megaphone. It is the previous lower lows and higher highs that make this pattern obvious for the investor. The slopes of the resultant trend lines distinguish this pattern from other similar, but different formations. The trend line created by connecting the intermittent highs must always be sloping upwards, while the one connecting intermittent lows must clearly have a downward direction. If one of these trend lines is somewhat horizontal, or they both slope in the same direction, then the formation cannot be considered a broadening top. At a minimum, there must be at least two minor lows and two minor highs before the pattern can be considered to be a proper formation. These price highs and lows must be clearly distinctive within the charted range as per the example below.
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Source: http://www.thestreet.com/p/_rms/rmoney/technicalanalysis/10269434.html Linear regressions statistical studies have shown that during the formation of these types of patterns, volume tends to follow the price movement being exhibited within the formation. Consequently, when prices are rising, the volume of activity also tends to be rising. The reverse is true in the opposite direction. The point of interest for investors is that the breakout points that occur signal the formation has ended and a significant price move should be anticipated in the direction of the breakout. Breakouts are the prices above and below the two trend lines that have been formed by connecting the relative highs and lows within the formation that produced the image of the megaphone. What is distinctive about this formation is that it can be clearly seen that during its consolidating phase, every time the price has approached the identified trend lines, it retreats to within the previous range. As a result, when it finally pierces one of the trend lines, it becomes a very strong historical signal that the directional move established will continue significantly into the future. Trading Considerations The proper interpretive significance of this formation is dependent upon the direction of the breakout. When breakouts have occurred on the upside, the formation was in essence a consolidation, and the established uptrend will continue. Breakouts on the downside, however, represent the signaling that a reversal has occurred. Many analysts consider the formation of a megaphone top chart pattern to be a bearish indication. Statistical research, however, is inconclusive in its findings. From a tactical perspective in making decisions towards anticipated price movements, the general rule of thumb is to take the largest range exhibited within a broadening top formation,
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and then add it to the previous highest high exhibited, in order to obtain an anticipated target price. When the breakout occurred on the downside, this range figure is subtracted from the lowest previous low exhibited for a similar target assessment price. Though these types of formations have been shown to be exceptionally accurate in predicting future movements in the direction of the breakouts, every investor must be prepared for a failure, even though its occurrence appears to be exceptionally rare. The generally accepted methodology is to have a stop loss a certain percentage below the previous relative high in an upwards breakout, and above the previous relative low in a downward break. As these types of formations can be the first indication of a significant reversal of trend, if this were to occur, and an investor has taken the proper position, it is highly advisable to adjust the stop loss order to subsequent exhibited relative highs and lows so as to maximize the benefit from having entered the trend reversal at the very beginning. Broadening or megaphone tops represent an exceptional tool for the trader to make proper investment decisions that will culminate in successful results. These patterns, unlike most consolidation formations, are characterized by ever-increasing tops and bottoms resulting from increased volatility in price ranges with the passage of time. Volume can be seen to be increasing significantly during intermittent price rises and falling during intermittent reversals. Since the bullish signals produced by the rallies are evidently short lived, when a reversal breakout occurs, more often than not, it is the beginning of a significant downward movement that can prove to be long-term, and, thus, representing a truly extraordinary investment opportunity. Broadening top formations that have occurred after an exceptionally long previous uptrend signify that speculators have produced unrealistic expectations; as a result, the reversal will usually result in an extremely significant correction. Traders who can properly identify a broadening top megaphone chart pattern can be expected to obtain extraordinary trading results upon implementation of the proper position.
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Cup and Handle The cup and handle chart pattern is generally regarded as a bullish continuation pattern that represents a significantly long consolidation, followed by a breakout upwards. It is attributed to William O'Neil and was first introduced in his book called "How to Make Money in Stocks." As the name implies, the cup and handle formation resembles a tea cup on the chart. The length of time necessary for the pattern to form can vary from several months to a year. The general form, however, is always the same. It shows a distinct curve continuation pattern, at the end of which the established upward trend stalls and prices move downward to form the handle. When the handle pattern has been penetrated upward, it is usually followed by a significant appreciation of price.
Source: http://stockcharts.com/school/doku.php?id=chart_school:chart_analysis:chart_patterns:cup_with _handle Formation This type of chart pattern is characterized by a distinct upward move, which then stops and sells off. This selloff is the critical part of this pattern formation. Once it has occurred, the market in question basically trades in a relatively narrow range downward for an extended period of time and demonstrates no clear trending movement. Once this has occurred, the price moves back up towards the previous high. The trading range during this period can be seen forming a distinct
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handle formation relative to the large cup base of the preceding trading time period. Once this handle formation is broken, the market moves distinctly higher and continues the previous upward trend. Generally, analysts confirm the formation of a cup and handle chart pattern by demanding a minimum 30 percent increase from the low point in the cup before it the formation of the handle. In addition, there must be a period of very high volume somewhere during the rise and creation of the cup. All the cups must have a distinctive U-shaped base with a handle, so as to distinguish it from a simple rounding bottom formation. In addition, the handle should have a minimum one to two weeks duration period. There are several aspects of this sort of chart pattern that should be noted in order to best to evaluate its potential as a trading signal. It is critical in this type of pattern to note what type of price movement occurred prior to the formation of the cup and handle. As a general rule, the larger the prior rise was before the appearance of a cup and handle chart pattern, the lower the probability for a significant breakout once the pattern has been completed. As there has already been a significant price appreciation prior to the formation of the current pattern, this weakens the momentum of the price movement for a continued upward appreciation. Trading Strategies Strategies for determining the upward price potential usually entail determining the height of formation from the lowest low that exists in the cup to the high produced at the cup lip on the right-hand side. Adding this differential to that high produces the target price. However, statistical studies show this methodology has never produced a success rate of over 50%. This means that less than half the breakouts reach this level. The smaller the percentage taken of this previous range exhibited in the cup, the larger the likelihood of achieving that priceperformance. Consequently, when trading this formation, one should look for extended depths within the cup, and then take a relatively modest percentage price goal in order to maximize trading results and performance. This chart formation lacks the statistical certainties of other formations. It is also characterized as being difficult to truly objectively recognize. Investors do look for this type of pattern, nonetheless, and there are certain techniques that can be used to improve the likelihood of undertaking a successful investment. Often, when this pattern materializes, a breakout occurs from the handle above the right cup lips previous high, and the price will increase but then come back to the lip high price. When this occurs, it tends to act as a confirmation that the upward trend will resume. Waiting for this confirmation, and only entering after the prices return to the upper lip before taking on a long position, greatly improves the probability of a successful trade. As with any chart pattern, one should always be prepared for formation failure. With this particular type of pattern stop loss, orders are placed somewhere below the handle low in order to minimize losses. The rule of thumb is generally the place stops at 12 1/2 percent below this price, as the handle becomes a support level for corrective retracements. Consequently, an investor would want to see a distinct penetration of that support level, prior to recognition of a loss. In order to take advantage of the upward movement, it would be beneficial to have a moving stop 12 1/2 percent below clearly defined support levels, so as to maximize potential
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future profits. This tactic will eventually force you into a profit, but protect you from a potential reversal that would eliminate entirely any possibility of a successful result. As with almost all chart patterns, volume of trading activity is a useful confirmation for implementing a position when a signal is recognized. The cup and handle formation is no exception. Generally speaking, the larger the volume on the upward breakout, the higher the probability that the upward trend will resume and continue. The cup and handle is just one of many successful chart formations used by investors to obtain gains from trading. The difficulty in using this chart pattern is its recognition, which can only occur through time-tested practice.
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Dead Cat Bounce Within investment circles, there is an adage that says even a dead can bounce if it falls from a tall enough height. The dead cat bounce chart pattern concerns a short term recovery in an overwhelming downward trending market. Whenever a price has moved significantly over a long period of time in one direction, investors will start to rethink about whether they are holding the proper positions. After such movements, those who were lucky enough to have recognized the trend from an early point are closing out their positions in order to recognize some profits. At the same time, especially in a bear market, certain value oriented investors are beginning to believe the bottom has been reached, and that it may be appropriate to take a long position. The final type of trader to enter in this scenario is one who will use a strategy based on momentum, and looks at his or her particular trading signals to try to identify an oversold market. All of these influences bring on a certain amount of buying sentiment, if only but for a brief period of time, which sends the market up. It is in situations like this that the dead cat bounce chart pattern appears. Formation A dead cat bounce chart formation is often characterized by a gapped down trading session. Some sort of news event happens that is so surprising to market participants that sell orders completely overwhelm what little buying demand there is. The price declines and opens at a much lower level. In addition, volume is exceptionally strong relative to what turnover was traditionally. It is not uncommon to see 20 times or more normal trading levels. After this, a bounce consolidation phase begins. The price starts to recuperate some of its losses. This recuperation, however, is usually short-lived, and the downward trend shortly thereafter continues.
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Source: http://www.mrswing.com/artman/publish/SwingTracker_stock_scan_/Trading_Dead_Cat_Bounc e.shtml Not all significant downward trends result in a dead cat bounce. However, statistical studies tend to show, 90% of the time this formation appears, there is an additional significant downward movement. The average decline, as measured from the high the day before the price gapped downward, to the ultimate low achieved subsequently, ranges as a decline in the 30 to 40% range. The average recovery tends to be in the 20 to 30% range from the low register on the bounce day. Trading Strategies From a trading perspective, the best way to profit from a dead cat bounce is to wait for a recovery high enough in order to take a short position. Generally, the percentage fall from that recovery high to the ultimate low ranges between 15 and 25%, a large enough fall in order to risk a trade. Based on historical studies, the recovery high should occur within two weeks of the appearance of the bounce. An appropriate position price should be determined at which the sell order should be placed. Trading dead cat bounces can be risky, however, as they have occurred because there has already been an extremely severe decline. As it is a high percentage trade, there is the possibility for low risk, short-term profit. However, dead cat bounces can statistically be shown to be low risk trading opportunities. They do not represent a situation for an investor to obtain a large successful gain. As the saying goes, you can throw a dead cat off from a high enough point and it will bounce. The bounce, however, will not be very high and the cat will still be dead. The primary attractiveness with this sort of chart pattern is that it represents an opportunity for an astute investor to make a quick small profit. The problem with this type of formation is the fact there has been an already tremendous deterioration and fall in price when it appears. As a result, the profit potentials for a trader are extremely limited. Consequently, care should be taken when considering entering trades because of the inherent background of this chart pattern. Though they represent opportunities, they can at times be precursors to a significant trend reversal. Therefore, whenever considering entering a position at the occurrence of a dead cat bounce, proper stop loss orders should also be in place. Any reversal in price to the high of the day previous to the gap down is an almost guaranteed signal that the pattern has failed. Should this occur and the investor is in a short position, losses should be terminated at this point. If an investor wants to trade a dead cat bounce, the odds are in his favor in producing a successful result, if he or she is not too greedy. It is highly recommended that when contemplating this sort of chart formation that the gap that has occurred be at least 20% of the previous days range, and that volume on the gap day is at least three to four times the recent daily average. In order to maximize profitability, a price needs to be determined on a subsequent bounce as an entry point. This bounce should occur in a relatively short period of time. If it hasn't materialized within two weeks, then there is no dead cat bounce. The continuation of the downtrend after the appearance of the bounce should last between three to six months. However, the further decline will be modest, but almost guaranteed. Where the dead cat bounce occurs relative to the historical price performance will determine the magnitude of the further decline.
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If the drop precedent to the appearance of a dead cat bounce chart formation happens after the appearance of a previous long term high, then the continuation of the fall after the bounce will be greater and the failure rate much less likely. It cannot be emphasized enough, however, that this particular chart formation only occurs after a dramatic fall in the price of a market has happened. At some point in time, every investment will begin to look cheap. And as the fundamentals of any successful investment strategy is to buy low and sell high, one should take particular care in utilizing the dead cat bounce chart pattern as an investment indicator.
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Diamond Tops and Bottoms The only difference between a diamond top and a diamond bottom during the formation of these types of chart patterns result from the price trend that precedes the formation. Diamond top chart patterns are preceded by an upward trend, while diamond bottoms have declining prices prior to appearance. Performance results of these types of chart formations are similar. Both serve as signals that the precedent prevailing price movements are about to reverse themselves when a breakout occurs on high volume. The historical studies done on this chart pattern seem to demonstrate a failure rate of approximately 25% for diamond tops, which is roughly twice the rate for diamond bottoms. As this failure rate is relatively high for diamond tops, using them as a signal for position taking purposes may not be well advised, unless they occur in conjunction with another indicator. When breakout occurs, the average declines appear to be around 20% for top formations, whereas the average rise from diamond bottom chart patterns upon breakout is in the 35% range.
Source: http://www.baresearch.com/education/technical_analysis/chart_patterns/reversal/diamonds.phpF For the formation of a diamond top chart pattern to occur, there must be an upward short-term price movement that leads to a minor high on the left side of the formation. Price is then expected to proceed to decline, in order to form a minor low, before turning around and moving higher again. They then reach a new high before tumbling down again to finish below the previous minor low. Once again, prices begin to rise, reaching another minor high before breaking down and penetrating the upward trend line on the right. These fluctuations that produce the relatively minor highs and lows will result in a diamond shaped formation when the
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various relative high and low prices are connected. It should be noted that the formation does not necessarily need to be symmetrical, as irregular diamond chart patterns are very common. Volume tends to be declining, especially during the latter part of the formation of this type of chart pattern, when the price range begins to narrow. When breakout occurs, trading volume is usually higher than normal, but this is not a prerequisite for this pattern. Generally speaking, however, these types of chart patterns are characterize by the right side volume being much lower when compared to the volume of trade on the left side. The formation of a diamond top chart pattern is considered a bearish signal. When breakout occurs on the downside, there is an excellent potential for a short sale with a profitable result. Support and resistance levels for diamond tops normally appear at the top of the formation. Diamond bottom formations are similar to those of tops, but in reverse. There is a clear precedent downward trend in prices prior to the appearance of the chart pattern. After this downward trend price has rebounded slightly, the range starts to expand, producing higher highs and lower lows. The price trend then begins to narrow with resulting higher lows following lower highs. The diamond formation then becomes evident when trend lines are drawn connecting the various limits of the price movements. Volume during the formation tends to recede, but this is not mandatory for diamond bottoms. As is characteristic in tops, there can be wide variations in volumes traded. Overall, nonetheless, volume tends to reduce overtime until the point of breakout, where volume is usually significantly higher. Trading Strategies As with any chart pattern formation, target prices need to be developed. With diamond tops and bottoms, the rule of thumb is to locate the highest high and lowest low in the formation and subtract the low from the high. This is normally considered the minimum price move to be expected upon breakout. Historical studies seem to indicate that these distances will be traversed 95% of the time when the breakout occurs from a diamond bottom and 79% of the time when the breakout occurs from a diamond top. Given this historical precedent, the use of this sort of methodology for achieving your profit goals when instituting a trade is highly recommended. Diamond top and bottom chart patterns form relatively infrequently on price charts. When they do occur, however, it appears that they do so more frequently at market tops rather than market bottoms. This appears to be quite logical and consistent with the shape of this type of formation, which appears to suggest an indecisive market, where one would expect more often after a strong bull run. Volume activity is extremely important in identifying a diamond formation and in helping not to confuse it with a typical head and shoulders pattern. This confusion can arise because of the upward sloping neckline in these patterns, which also can be used as an early entry point for the position, and therefore, result in a greater profit. Genuine diamond chart formations are always identified by decreasing volume during the second part of the price pattern. When breakouts occur from a diamond formation, they are almost immediately followed by a two to three percent movement in the direction of the breakout. What usually follows next is a return to that breakout level. If the price is for any reason is not supported at this point, and there is a retracement above or below depending on the type of breakout, the pattern must be
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considered invalid. Consequently, stop loss orders should be placed at these levels so as to minimize losses due to a formation failure. Diamond top and bottom chart patterns are extremely difficult to identify as they have characteristics that are very similar to other technical analysis chart formations. The distinguishing aspects of the diamond formation that the investor needs to master to properly identify are the upper and lower trading range and the volume behavior within the pattern. True diamond patterns are exceptionally rare; however, for the investor who has mastered their recognition, they represent an outstanding trading tool, since when breakouts occur, subsequent movements tend to be very substantial. Therefore, profit potentials are excellent.
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Double Tops and Bottoms A double top chart pattern is defined as the formation that occurs when the price has risen to a certain level and then drops back from that point, only to return to that same level and drop back off once again. A double bottom chart pattern is, in essence, the exact opposite of a double top. This bottom formation occurs when prices decline to a particular level, only to rebound and return a second time to that same level and to reverse once again upwards.
Source: http://www.investopedia.com/articles/forex/05/032805.asp
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Source: http://www.investopedia.com/articles/forex/05/032805.asp Interpretation The appearance of double top and doubled bottom chart patterns within investment markets is a fairly common place occurrence. When these formations appear, they signify the market in question is testing previously recognized limits. These patterns can clearly show the price points where other market participants have demonstrated that they will resist and support any further movement beyond these levels. The appearance of these types of patterns is usually regarded as strong signals that penetration beyond the established limits cannot occur. As a result, these formations are viewed as indicators that a reversal in trend is likely to occur. The proper identification of these types of chart patterns represents excellent opportunities for the initiation of profitable trades. One of the biggest problems concerning technical price chart patterns is that what historically appears to have been quite obvious is extremely difficult to identify during actual trading conditions. This can be particularly true as regards to double top and doubled bottom formations. As these formations arise with a high frequency in historical price charts, the successful identification and utilization of these patterns for trading purposes is very much an acquired skill that needs to be learned through practice over time. That being said, these patterns are relished by individual traders who recognize their utility for proper position taking in successful trading activity. One can react to their formation by one of two methods that could be characterized as either reactive or proactive. The tactics used by the individual trader depends on that person's character and personality. Strategies
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For those individuals who wish to be proactive in exploiting double tops and bottoms, the techniques used entails selling as the price approaches the identified top, and then re-purchasing and eliminating the position as the price declines to the bottom. Under this methodology, the investor is anticipating the reversal that is expected to occur. Traders who are more conservative in nature will stand by until the chart pattern has clearly been established, before entering into the appropriate position. This type of tactic reduces the risk of a double bottom or double top formation not actually completing the process of formation. It should be noted that though this is a conservative technique, at the same time, it significantly reduces the profit potential. The most conservative fashion for trading double tops and bottoms is to wait for the actual formation and then to implement a position when a breakout occurs in order to benefit from the anticipated reversal. Generally, one would like to see declining volume when the second peak or second trough is approached and rising volume at the break up of or below the second top or bottom. Double top and doubled bottom chart patterns are clear signals that the price movement has failed to break certain clearly established levels that are resistance barriers for double top formations and support barriers for double bottom formations. These types of chart patterns are generally considered reversal signals. A conservative investor will await their clear formation and a distinct breakout before entering a position. Profits, nonetheless, can be maximized when a trader becomes more sophisticated by actually trading the range established. Gains made during these range trading tactics are modest, but add to overall profitability. The risk, of course, is that the price moves out of the range, which is always inevitable. However, any loss that occurs during this price break would be modest, as the range trader would immediately reverse his or her position to take advantage of the trend reversal that has been identified by the breakout. Risk Management In order to limit risks for these types of formations, depending upon whether a double top or double bottom is involved, stop loss orders are placed at the identified tops and bottoms. The rationale behind this risk management technique is that as soon as the formation has been broken, this should be viewed as pattern failure, and as such, the investment position should be liquidated. This, however, is not always the case. Most investment markets are now dominated by large institutional participants and hedge funds. These players, during these types of chart patterns, will often liquidate their positions early in order to try to take advantage of smaller individual investors. Consequently, what arises are many stop loss orders on trades that would have been profitable, if left in place. Initiative Double top and double bottom chart patterns are common and therefore, represent opportunities for the investor to take advantage of what more often than not becomes a reversal in price movement. The successful utilization of these types of formations is always dependent upon the skills of the individual who has properly recognized them. Due to the frequency of the
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occurrence of these types of chart pattern formations, is not difficult for the investor who wishes to use them as signals for the implementation of trades to acquire the expertise necessary for the proper utilization. It is highly recommended, no matter what type of chart formation an individual trader wishes to utilize as strategies concerning his investments, to take the time to historically test the techniques anticipated to be used. Practice makes perfect. Individuals will find what true double tops and double bottoms are by this type of exercise. Once the techniques have been mastered, successful trading results are almost inevitable.
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Triple Tops and Bottoms One of the outstanding attributes of the chart patterns formations known as triple tops and triple bottoms is their exceptionally low failure rate. Some studies have shown successful trading possibilities over 95 percent of the time, when these types of formations materialize. One can successfully trade these opportunities both on and long and short break outs of established support and resistance levels. The greatest success, however, occurs when a trader goes long after the formation of a triple bottom, and short when the triple top chart pattern has been broken. Some research has suggested averaged gains approaching 40 percent. Gains are more likely in the 20 percent range based on a frequency distribution analysis. These are truly outstanding results. Volume can be important, especially in those circumstances when volume on the center bottom or top is below that of the last formation of a top or bottom. In these situations, the average gains tend to be even greater. In those circumstances when the opposite is true, though successful results can be expected, they are of a more modest nature.
Source: http://www.investopedia.com/university/charts/charts9.asp
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Source: http://www.investopedia.com/university/charts/charts9.asp Formation For every chart formation pattern, there are unique characteristics that will distinguish it from other formations. For triple bottoms and triple tops to occur, there has to be a clear support or resistance level that has been approached and repelled three times. During the beginning of the pattern, from the first to the second top or bottom, there appears to be a broadening right angled ascending or descending directional movement with a horizontal bottom or top and a consequential up sloping or down sloping trend line. Prices always need to stop their movement at or about the same level. The tops and bottoms must be clearly distinct. The price variations at these levels must be minimal. The center top or bottom is not significantly above or below the other two, as this would be an indication of a head and shoulders or reverse head and shoulders formation, which could entail differing consequences. The overall volume trend for triple tops and bottoms chart patterns is usually downward, and they are the weakest at the last relative high or low formation. This type of chart pattern usually takes a significant amount of time to form on a historical price chart. Volume behavior is not critical during these types of formations. However, they do possess a confirmatory nature when it comes to position taking. Historically, for each of the subsequent tops and bottoms that are recorded in a price chart, volume tends to peak preceding the formation of each individual top or bottom, with the first initial top or bottom showing the highest volume within the trio. The rallies or falls in prices for each of the individual high points or low points in the formation of a triple top or triple bottom chart pattern should be pronounced. The upper-level support and lower-level resistance levels that appear represent the area where consideration should be taken for the implementation of a position. Regardless of which type of formation is under observation, break out of this identified channel on the up side represents a long trading opportunity, while with the penetration on the down side, one should consider entering a short position. Generally, the trader would prefer to see a decreasing volume of activity for each subsequent high or low that is exhibited within the chart pattern. These formations tend to be more successful when they occur after a significant move upwards or downwards. In other words, the investor should be more suspicious of a triple bottom that occurs after a significant or intermediate uptrend, rather than one that occurs after prices have fallen substantially. The opposite is true for triple tops. Triple tops and bottoms that form when no significant price move has occurred do not tend to be very well separated. When this happens, one should be suspicious. This should be viewed by the trader as a price pattern that does not represent a true formation of a triple top or bottom. One should be always weary of this type of visual formation that has not occurred after a significant substantial movement in one direction or another. Trading Strategies
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When trading triple tops and bottoms, a target price is derived by adding the differential between the highest high and the lowest low that is evident within the chart pattern to the breakout point, which would be the upper trend line for a triple top and the bottom trend line for a triple bottom. The entry point for a long position would be the point of penetration represented by the upper resistance line that has been identified, while the entry point for short position would be that point as shown on the lower support line. Re-penetration of prices back into the trading range after a breakout has occurred is not uncommon, before the reversal of prices continues in the direction of the original breakout. Consequently, an investor has two possible tactics concerning stop losses. One would be to place to a stop loss back at the penetration point. This tactic entails recognizing a modest loss when these instances of retracements occur. He or she would then enter once again when penetration reappears. This may create a series of modest losses that are later recuperated. An alternative strategy would be to place the stop at the opposite trend line in the formation. This would minimize the number of losses; however, when a true formation failure occurs, the loss that occurs using this tactic would be substantial. When an anticipated reversal in trend appears, the trader should institute a series of trailing stops at identified support levels in order to maximize the profit potential of the trend reversal.
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Flags and Pennants It frequently happens that when an investment market is trending, the market will stagnate over a certain period of time before deciding to continue or reverse the previous trend established. The chart patterns that form during these periods of consolidation often resemble what are referred to as flags and pennants in technical analysis terminology. The occurrence of these events represents excellent opportunities to undertake an investment position. Formation When connecting the relative highs and lows during a precedent time period in a historical price chart, if the subsequent trend lines run parallel, resembling a small angled rectangle, the chart pattern that has been formed is referred to as a flag. If these two trend lines, on the other hand, converge to a point to resemble a triangle, this type of formation is called a pennant. Pennants are formed during periods of contracting prices and represent a consolidation of price activity. Pennants are distinguished from similar formations referred to as triangles, in that the pennant is not symmetrical, and does not possess a horizontal trend line. For an investor, being able to identify flags and pennants will allow him or her to be able to establish entry points for positions. This, in turn, can produce profitable results by following the existing underlying trend price movements that have been clearly established.
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Source: http://www.investopedia.com/university/charts/charts6.asp Following a distinctive price movement that has occurred in an investment market, activity will more often than not stall, and perhaps even retrace the movements slightly before resuming in the direction of the established underlying trend. When this type of situation materializes, prices can be observed to be trading within a relatively narrow range. Upon the observance of such an event, the potential investor can connect the relative highs and lows in order to obtain trend lines for signaling purposes. When price trading activity remains within the identified two trend lines, the price stagnation of the market in question remains intact. Trading Strategies When the price starts to trade outside the identified consolidation range, and moves in the direction of the previous established trend, this is a distinct signal for the investor to contemplate the possibility of entering a position. There are various techniques that are utilized by traders to take advantage of these chart pattern formations. The most obvious tactic is to wait for a price movement that is a certain amount above or below the breakout point to ensure that a false signal has not been established. Once the investor is confident that the breakout is in fact real, he or she undertakes the appropriate position. A more conservative approach is to wait and see if a retracement to the original trend line occurs. If that trend line supports the price and then proceeds to move in that direction of the underlying trend, the probability of success of the position is greatly enhanced. Though the likelihood of a profitable trade increases, the investor also runs the risk a retracement does not occur, and, therefore, the position entry will be less than optimal towards the maximization of profits. When implementing or considering the entry into an investment position, price goals need to be established prior to undertaking the position. The common practice with the utilization of flag and pennant chart formations is to measure the distance from the highest high to the lowest low observable in the chart pattern that has been identified. Upon entry, the exit price for liquidation of the position would be the range that has been identified, added or subtracted from the entry price, depending upon whether a long or short investment was undertaken. Not all subsequent movements will achieve these range goals that have been set. As a result, the probability of successful trades can be increased by taking simply a certain percentage of the range as the profit goal.
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Proper recognition of chart formations and the breakouts that arise from these patterns is a skill that needs to be developed by any investor. This skill can only arise from experience and practice. Within the context of flags and pennants, this is especially important, if one does not want to be fooled into an entry because of a false signal. Such occurrences will always result in unwanted losses. When using these types of techniques for investment purposes, no one should blindly just start trading without first developing a comfort level and mastery of the techniques involved by trying to replicate trades on a blind basis using this historical data that is readily available. Only when the strategies and techniques have been proven in such a manner should an individual actually contemplate using real capital. Regardless of the expertise developed, no successful trader enters a trade without being prepared for the worse to happen. As per Murphy's Law, "Whatever can go wrong, will go wrong!" Whenever a trade is implemented, stop loss orders should also be placed in order to limit losses, when and if they occur. As it concerns pennants and flags, stops are normally placed a certain modest percentage above or below the original trend lines that were penetrated. The trend line itself should not be the stop loss limit, as often during these formations these original trend lines tend to serve as support levels during retracements. Consequently, after resumption of the original established price trend, retracements can often be observed to the original breakout points. As a result, in order to avoid the creation of a loss that would have resulted in a gain, the stop loss point needs to be below or above the original entry signal to ensure that formation failure has occurred. Flags and pennant chart formations allow an investor to take advantage of a temporary stagnation in an established trend. These patterns represent exceptional opportunities for profits with limited downside risk, as the stops are easily identifiable and when triggered represent modest losses relative to the gains achieved during successful results. Flags and pennants are established tools for successful investment strategies.
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Head and Shoulders Chart pattern formations are generally classified on the basis of their significance to the underlying current trend that has been generated by the price movements that are graphically represented on a historical chart. Reversal patterns are those types of formations signaling the end of the trend in the probable movement in the opposite direction. Head and shoulder chart patterns are one such reversal formation that is actively utilized by investors in order to undertake trades in an investment market. One of the most popular chart patterns used by investors is called the head and shoulders top formation. The reason for its popularity is that some studies have shown that up to 93 percent of the time, when a breakout occurs on the downward side, the likelihood of continued downward movement is very high. Another reason for the popularity of this formation is the relative ease of recognition. It is easy to see on a historical price chart, since it simply consists of three consecutive high points, with the middle high point higher than the ones preceding and following it.
Source: http://www.investopedia.com/terms/h/head-shoulders.asp Formation Characteristics Typically, the highest volume can be seen during the formation of the head, or previously during the formation of the left shoulder. Following the formation of the head, there is always a significant drop in volume. A trend line drawn along the two low points between the three peaks forms what is called the neck line. This trend line can neither slope upwards or downwards and the direction is considered inconsequential, though it has sometimes been correlated as a predictor of the intensity of the subsequent price decline. The head and shoulders top pattern often arrives with a variety of shapes. Sometimes they can have multiple shoulders on either side of the head. This formation typically appears at the end of a long movement of prices upwards. If the prior uptrend has been of a relatively modest duration, the subsequent correction downward after the appearance of the head and shoulder chart pattern usually results in prices falling back down to the original start of the preceding uptrend.
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Trading Strategies When using the head and shoulders chart pattern as a trading signal, most traders calculate a target price by measuring the distance from the highest price reached at the head to the corresponding point on the neckline drawn below. As mentioned previously in this book, these target prices are just customary practices used by traders, and research has shown that the extent of movement downward upon a breakout of a head and shoulders formation will not always reach this target. The smaller the percentage of profit desired relative to the target range increases the probability of a successful trade. Entrance to the trade occurs when the price breaks downwards below the neckline. Since this type of chart pattern rarely fails, most traders do not insist upon a confirmation signal before undertaking a position. On rare occasions, subsequent to breaking under the neckline, prices will recuperate and move higher. Consequently, a trader should always protect himself or herself by having a stop loss order a modest amount above the original neck piercing point of entry, or above the higher of the two previous lows represented by the shoulders. It is not uncommon for the price to recuperate to the neckline, and then fail to penetrate, and proceed sharply lower. Some traders use this as a signal to increase their position. When considering such a strategy, the trader should always be certain that prices have fallen back underneath the neckline a minimum amount. When a chart formation on a historical price chart exhibits the opposite or mirror image of a head and shoulders top formation, it is referred to as an inverse head and shoulders. You can think of it as someone standing on his head. However, it generally exhibits the same characteristics of a normal head and shoulders chart pattern with the same potential results. There is a clearly identifiable low-price with upside down shoulders to the left and to the right of the midpoint low. Once the neckline is broken, it signifies that significant resistance has been overcome and represents an excellent opportunity for upward movement. This type of chart formation signifies that the previously identified downtrend has reversed itself, and that prices should move appreciably higher in the opposite direction. As with the normal head and shoulders formation, a conservative investor may wish to witness a retracement back to the neckline and demonstrated support before undertaking an investment position. A more aggressive trader will simply buy when the neckline is broken because of the high probability of success that has been demonstrated historically. The type of strategy employed by any particular individual will be a function of his or her trading personality. For any reversal pattern formation, such as head and shoulder chart patterns, when the neckline is broken, it immediately becomes a resistance level of particular importance, especially for those instances when formation failure occurs. These data pattern formations will often show retracements back to the original neckline that signaled the pattern reversal. During the overwhelming majority of instances when this occurs, the price will be successfully supported at that level and then subsequently resume the reversal of trend that has been demonstrated and signaled. This does not happen each and every time, unfortunately. Consequently, upon implementation of any trading position based on the penetration of the neckline, one should also have stop loss order in place, a certain percentage above or below the penetration point,
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depending upon whether a normal or inverse head and shoulders formation is under consideration. The head and shoulders chart pattern is considered to be one of the most reliable and classic technical analysis tools available for a trader in the investment markets. However, any tool is only as effective as the person who has learned how to use it. Because of this fact, it cannot be emphasized enough that prior to taking and risking any real capital in no matter which market, a trader should hone his skills to perfection. As a result, prior to using any of the chart patterns explained in this book, it is very important for the individual to practice their recognition on historical data that is readily available.
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Island Reversals Another relatively common chart pattern used by investors for trading purposes is referred to as island reversals. The appearance of a gap when it occurs alone provides evidence that there has been an important development concerning the fundamentals or psychology of the traders that has caused this movement to occur in market price action. This sudden movement in price by an investment can only signify a significant change in demand. When these gaps appear within the formation of an island on a price chart, they can represent an opportunity for the investor for a low risk, high probability trading opportunity. Island reversals typically appear after an extended trend upwards or downwards and always begin with a price gap trading day in that direction, usually the result of some sort of unexpected news. This unexpected breakout in the direction of the trend occurs with an exceptionally high volume relative to average previous trading activity. The price movement, however, cannot maintain itself, and after several days, prices fail to move significantly in the direction of the trend. Market participation fails to sustain the movement. What usually happens next is the appearance of some sort of fundamental news event that contradicts the original information producing the first gap, and a new gap appears in the opposite direction Studies have shown success rates of as high as 87% for tops, and 83% for bottoms. The problems associated with this type of formation are that the gains that can be acquired are usually modest relative to other types of chart patterns. As a result, they should be considered for investment positions that would be held for only a relatively short period of time. As pullbacks and throwbacks are quite common, conservative investors will delay taking a position until this action has been completed and prices reconfirm their breakout direction. Formation Characteristics Island reversals are generally easily identified. Both of these types of reversals, regardless of whether they are bottoms are tops, begin with a gap movement in the appropriate direction followed by another gap in the opposite direction. The first gap is usually referred to as an exhaustion gap, followed by a second one referred to as a breakaway gap. The gaps materialize usually at the same price level, but are not necessarily the same size. It is important in the identification of an island reversal that the gaps occur at the relative same price level. The pattern that is evident is what can visually be identified as a type of island. Trading volume should be accelerating at the time of the initial breakout gap, as well as the subsequent reversal relative to the volume that preceded each of them.
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Source: http://www.shareselect.com.au/knowledge-bank/Technical-Analysis/Gaps-IslandReversal/ Trading Strategies The target price for an island reversal chart formation is usually arrived at by taking the range represented by the highest high and the lowest low identified in the pattern, and then adding or subtracting this difference appropriately. As a result, for an island bottom formation, this differential would be added to the highest high, whereas for an island top chart pattern, it would be subtracted from the lowest low. The price is arrived at represent potential targets. These ranges are rarely achieved in subsequent movement, and simply serve as a point of reference and guidance. Price movements subsequent to a breakout, traditionally show reluctance in continuing the directional movement demonstrated by the breakout. After a breakout occurs, prices often are likely to reverse direction and recover before resuming the trend demonstrated by the breakout. Consequently, when trading this type of formation, it is often advisable to wait for the pullback to the original breakout level before assuming an investment position. In other words, there has to be a clear piercing of the trend line and a return to that approximate level before entry into a position is contemplated. Though these formations have a demonstrated low failure rate, the subsequent movement upon their creation is typically been modest. Profit expectations on the part of the trader should, therefore, be similar. The best way to profit from these sorts of chart patterns is to wait for penetration and then subsequent support to appear at the previous trend line identified during a reversal, followed by the resumption of the original trend demonstrated upon breakout, before taking a position. After a modest gain has been accomplished, liquidate the investment. Though these types of chart patterns are actively used by traders because of the frequency of their appearance, unlike other chart formations, these patterns have historically been shown not to be signals of significant large trend reversal movements and should be utilized accordingly.
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Investors should note that the formation of island reversal chart patterns are usually news driven and occur because of conflicting informational events that arise within a relatively short time frame. As a result, it would be beneficial for the trader to be aware these news developments in order to produce profitable results in trading activity. Formation of island reversals without any news rationale behind them that can be clearly identified should be considered somewhat suspect on the part of the trader contemplating an entry because of the identification of this type of pattern on a historical price chart. When prices have trended upwards or downwards over a significant period of time, it is not uncommon to view a gap price day in the direction of the trend. Subsequent trading over the next few days will usually occur in a relatively narrow range and then be followed by a gap trading day in the opposite direction. The formation is easily identified and represents an island. Such situations are not uncommon and have been shown to produce modest profitable results when treated properly. It is a formation that can be used by any investor to increase his or her wealth.
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Ascending Triangles The chart formations referred to as ascending triangles are probably one of the most popular patterns among investors who use technical analysis tools to make investment decisions concerning their capital. The reason for this popularity is the strong average return documented in historical studies when an upside breakout occurs. Some research indicates an average return of 44%. When this data is viewed from a frequency distribution perspective, however, the return is more like 20%, which is actually quite respectable. One explanation of the price movements of an ascending triangle concerns the fact that for most investments, during certain times, there will be an adequate supply of the investment available within a certain range. The point at which that supply becomes depleted causes a breakout of the price from the formation, forcing a sharp move higher. If demand continues to materialize, the prices remain strong. Otherwise, the investment falls back onto itself and either regroups for another attempt at rising, or continues downward. Formation The pattern is considered relevant when the price movements in an historical price chart produces a horizontal trend line when the relative minor highs are connected, as well as an up sloping trend line when the relative minor lows are connected. These trend lines intersect to reveal the characteristic triangular pattern. Volume generally diminishes as prices range between the support bottom trend line and the resistance top trend line. Ascertaining an ascending triangle on a daily price chart is not difficult, and perhaps too simple, as it is probably one of the most misidentified chart formations in technical analysis. If at any time a trader questions the validity of a particular chart pattern, the likelihood is that there are other investors who share the same feeling. The use of chart patterns as successful tools, by a trader, requires recognition as such by the market. As a result, if you do not properly recognize the chart pattern, the probability that the event will produce the results that you anticipate is greatly diminished. In an ascending triangle, the horizontal trend line represents resistance and should have demonstrated several attempts of a lack of penetration where the price falls to this support trend line underneath and is repelled. The ascending support trend line on the bottom is always sloping upwards, from which derives the name of this formation as an ascending triangle. The top horizontal trend line must have demonstrated resistance at least twice and should have the upward sloping support trend line underneath. During the formation of this triangle, volume is initially strong, but then reduces itself until the occurrence of a breakout. Volume is typically low precedent in this breakout, as an indication that the formation is amassing strength for the eventual penetration. When this upside breakout occurs, volume is typically is much heavier, but this is not considered a prerequisite in this particular pattern formation. It is not uncommon for a breakout to occur and then subsequently be supported by the bottom trend line before the final breakout and a significant upward price movement occurs and results. Once the final penetration occurs, prices tend to rapidly rise and
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volume increases dramatically, causing the momentum upward to increase. At some point, eventually prices tend to level out and volume returns to normal. It is not uncommon for the upward trend to continue for several years following the initial lower trend line support that was identified.
Source: http://www.chartpatterns.com/ascendingtrianglecharts.htm Trading Strategies One market practice for determining a target price to be achieved after entry into a position is to take the distance from the high point of the horizontal upper trend line and the low point of the lower bottom trend line and then to add that differential to the breakout point of the formation. Not all movements subsequent to breakout will move this distance. By taking only a percentage of this range, a trader can greatly improve the likelihood of a profitable trade. When a breakout occurs, it is usually followed by a significant movement upwards. This does not always happen, and any trader should protect himself by having stops placed at the penetration point of the lower trend line. Should this support level be penetrated, it usually signals that prices will continue downward and should be considered not only as a stop loss for the original trade, but also as an entry point for a complete reversal of position. Some research tends to suggest that when this event happens, prices tend to drop another 20% when a downward breakout occurs. As is evident in the example above, ascending triangles must be confirmed with a general pattern of decreasing volume, as the formation materializes. After the breakout, this volume pattern will change and start to increase together with increasing prices. Should the investor have the good fortune of having discovered a significant resumption of an uptrend, that individual may want to institute a series of trailing ascending stops placed at identified support areas in order to maximize the return on the trade.
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An ascending triangle is considered a bullish chart pattern used in technical analysis that is rather easily identifiable due to the distinct shape created by the two trend lines. It represents a consolidation period of the previous established upward trend. Once the breakout occurs, investors aggressively enter the market, causing the price of the investment to move higher, usually accompanied with increasing volume. It is an extremely popular chart formation sought by investors due to statistics showing a high probability of profitable trading results. When failure does occur, it usually signals a reversal of the trend, such that any losses incurred can be recuperated and produce a net profit when both sides of the trades are combined. The risk with this type of chart formation lies in fact that it is easily misidentified and misinterpreted. There are many types of triangle chart patterns of which the ascending triangle is just but one. As a result, any trader who wishes to use this formation for trading purposes must fully develop his skills in its identification so as to achieve the results that he desires. Before trading any kind of triangle, the investor should have practiced their recognition on historical data to prevent mistakes.
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Descending Triangles The descending triangle chart formation is similar to the ascending triangle chart pattern when viewed as an opposite perspective. In this formation, prices rise to meet a downward sloping trend line that is formed on the top of the pattern. Upon reaching that trend line, they fall back. Subsequent to this event, they rebound off a horizontal lower trend line that exists along the base of the formation. Unlike some other types of triangles, the volume pattern for descending triangles tends to recede as a break out is approached. When a break out occurs, the volume on the breakout day appears, according to studies, not to be significant. Subsequent to the downward penetration of the lower horizontal trend line, it is not uncommon for prices to rebound and then again be repelled by this lower trend line, which has become a resistance level. The descending triangle chart pattern represents a consolidation during a previously identified downward trend. It represents a perception on the part of certain investors that due to the already significant fall in prices, the investment has become somewhat undervalued. These traders, however, are in the minority, and when a break out below the horizontal support level that has been identified occurs, prices continue their downward movement. Value oriented buyers realize their mistakes, cover their positions, intensifying a downward pressure on prices.
Formation The chart pattern represented by a descending triangle is rather distinct, making it relatively simple to identify. The formation is characterized by distinctive support at a relatively stable level, where prices rebound each time that level is reached, but in an ever decreasing manner, such that when the relative highs are connected, an observable downward sloping support trend line is revealed. Similar to a ball bouncing off the floor, each high price achieved is lower than the previous one. Volume during this formation period tends to be decreasing in size. Though this is not always
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the case, volume on the day the lower trend line is penetrated typically is much higher when compared to the previous days trading. Unlike with ascending triangles, the price movement post-breakout is generally of a short to intermediate term nature. It is not uncommon to see these types of chart patterns occurring just prior to a total trend reversal. Triangles as a type of formation are relatively easy to identify, and at the same time, just as easily misclassified. Within the descending triangle chart pattern, though the trend lines may meet all requirements, if the investor does not confirm any decreasing volume pattern, he or she has not found descending triangle. Making investment decisions based upon a misinterpreted chart formation could cause results to be less than expected. The successful use of chart formations as an investment tool depends not only on an individual trader recognizing the pattern, but also upon recognition by the market. It is always better to be safe than sorry. If at any time there is any doubt as to the true existence of a particular pattern, it is best to ignore the signal, and to look elsewhere for a more definitive indication. Trading Strategies The problem with descending triangle chart patterns is that research tends to show that the failure rate for a downward break out to occur can be relatively high, with some studies showing unsuccessful indications running as high as 45 percent. As a result, it may be advisable to use this particular formation in conjunction with other signals before contemplating undertaking a position. Though descending triangles appear to be very similar to ascending triangles, break out occurs below the bottom trend lines only approximately 55 percent of the time. In other words, when the formation occurs, a downward penetration of the bottom trend line will only happen for roughly 50 percent of these formations. When such a break out does occur, however, the evidence suggests that there will be continued significant downward movement up to 96 percent of the time. The continued downward move, however, averages only 19% with a frequency distribution analysis suggesting a far more modest return. The average returns for break outs that occur on the upside are far superior, with certain research demonstrating an average price move of 42% when this type of event occurs. As a result, an investor has an opportunity to either take a short position or a long position, depending upon the signal that is received. As with ascending triangles, the target price is arrived at by identifying the relative highs and low points that are used to draw the trend lines, and obtaining the differential between the two. This range is added to the breakout point, whether it is upwards or downwards, in order to determine a target price. This represents the relative ideal level that one would wish to be achieved after taking the appropriate position, based upon which trend line had been penetrated. As the average price movement upward is far greater than the one that occurs during a bottom trend line penetration, should an investor decide to take a short position based on this type of
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signal, you would be well advised to have a more modest goal than that one as represented by the target price. Regardless of what position is taken, formation failure is considered to have occurred when the price does not move in a direction intended, but actually reverses itself and penetrates the opposite trend line of the chart pattern. Thus, for the trader who has undertaken a long position, he or she should have a stop loss at the point the price would cross the bottom trend line. If the position undertaken was short, that stop loss should be placed at the penetration point of the upper trend line. Like ascending triangles, when failure occurs in a descending triangle, regardless of the type of position, it is often an indication that the underlying trend has resumed or there has been a complete reversal. Therefore, a trader has an excellent opportunity to recuperate the losses incurred upon the initial position by reversing himself or herself when a chart pattern failure occurs.
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Ascending Wedges Ascending wedges are formed when two trend lines drawn connecting intermediate high points and intermediate low points result in two upward sloping lines. These types of chart patterns can both produce a widening formation at the end, or one that narrows in scope over the time frame represented in the historical price chart. Regardless of the type of wedge that is being formed, one can view price movements that are generally moving upward. The significant difference between the two is that when a widening wedge appears, the upper trend line is ascending at a faster rate, and, therefore has an upward slope that is greater than the bottom trend line, demonstrating a broadening price action series. Widening wedges are characterized by slightly increasing volume as the breakout is approached, whereas narrowing wedges tend to show a decreasing volume at this point. Ascending widening wedges are the preferable chart pattern, as some research has demonstrated that as much as 94 percent of the time, when the penetration of the bottom trend line occurs, there is a significant downward movement in price that follows. Though the high percentage of success upon the bearish break out the bottom trend line is attractive, when that break out occurs, the continuing downward movement and prices is more often than not rather modest.
Formation An ascending wedge chart formation essentially resembles a megaphone. When this formation is of the widening variety, the mouthpiece of the megaphone would appear on the bottom left of the chart; the opposite would be true for a narrowing ascending wedge, where the mouthpiece appears in the upper right of the historical price chart. Both trend lines must be upward sloping. For narrowing ascending wedges, the bottom trend line has a higher slope than the upper one. Conversely, for widening ascending wedges of the upper trend line demonstrates the larger slope in contrast to the bottom trend line. For a true wedge to be in existence, neither of the trend lines can be horizontal.
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This chart pattern is not considered formed unless the trend lines that appear have been struck or nearly struck by price action at least three times on each trend line. An investor who has identified this type of formation is seeking confirmation of the reversal of the uptrend by the penetration of the bottom trend line. Though breakouts can occur on the upside, they are less reliable in nature. If the break out occurred downward and then moved back in to where price action has ranged historically as presented in the chart, this may signify that the bottom trend line boundary was incorrect and must be redrawn. The distinctive characteristic of ascending wedges is their megaphone shape. This type of appearance is not usual for broadening formations over all. What further distinguishes ascending wedges is the fact that the megaphone is pointing upwards. The distinguishing characteristic between the two types of ascending wedges is the fact that widening wedges generally demonstrate increasing volume during periods of rising prices, and decreasing volume when prices are falling. Though this volume pattern has been demonstrable, it is not considered a prerequisite for this chart pattern recognition. When prices finally penetrate the bottom trend line, it is a signal that a breakout has occurred and prices will continue to move downwards. It is not unusual for prices to return to and even re-penetrate upwards the bottom trend line. Pattern formations have been observed where this type of event can happen several times, and the trader should be aware of this possibility. The most successful formations of this type of chart pattern are those where prior to final breakout downwards, prices start moving up after having touched the lower trend line and then stop their upward movement before approaching the upper trend line, only to reverse themselves and decisively penetrate the bottom support level. It is important to note that this partial rise retracement must start from the lower trend line and not from somewhere in the middle of the identified trading range. This particular type of price action in this type of chart pattern has proved to be exceptionally successful for trading purposes. Trading Strategies The target price for trading purposes is determined by the lowest observable daily low that occurred during the formation of the chart pattern. When a breakout occurs below the bottom trend line, investors should expect that prices will continue downwards at least to the level of the previously determined lowest low that existed in the formation identified in the historical price chart. The research seems to imply that the probability of a successful trade is in the investors favor when a breakout occurs on the down side in this type of formation; the downside movement, however, can be modest relative to chart indicators. Retracements are not uncommon, and penetration upwards of the bottom trend line can happen fairly frequently. This could be an indication that the formation has failed, but does not necessarily signify that such an event has occurred. The conservative investor could use his bottom trend line as a stop loss point in order to liquidate his or her position, if such a retracement were to occur. As target price achievement occurs more often than not with this particular chart pattern, the conservative investor recuperates his funds over the long run by trading every signal. More aggressive traders would demand the penetration of the upper trend line to signify that a true formation failure has happened. However, these types of investors will find that when a loss does occur, it is
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substantial, but at the same time he or she is increasing the statistical success rate of his or her trading activity. The type of strategy to be chosen is dependent upon the character of the individual who is making the trades.
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Descending Wedges Though descending wedges resemble ascending wedges in their megaphone shape, they differ not only in the fact that the direction of the megaphone is being pointed downwards, but they also occasionally differ in the price action that occurs when and if a break out happens. Descending wedges are characterized by two down sloping trend lines. When the upward down sloping trend line has a greater downward slope than the bottom trend line, the mouth of the megaphone image will be on the right-hand side of the chart pattern. This type of formation is called a narrowing descending wedge. In contrast, when the opposite is true, the bottom trend line has a more negative slope than that of the top trend line, and the megaphone image that is produced points downward with the mouthpiece located on the left. When this has occurred, the chart pattern is referred to as a widening descending wedge. What is interesting about descending wedges in contrast to ascending wedges is that the narrowing descending wedge can be viewed as a reversal formation, whereas widening descending wedges acts more like a consolidation of the prevailing trend. Volume action is also very different. In regards to the descending widening wedge, volume tends to increase over time, while with the narrowing descending wedge, this volume activity tends to decrease.
Source: http://www.aboutcurrency.com/content/view/63/112/ Formation Both the widening and narrowing descending chart patterns are characterized by down sloping trend lines that limit a period of oscillating price movements. They are differentiated by the fact that the narrowing descending formation will have a top trend line with the largest downward slope, while with the widening descending formation, the largest negative slope is possessed by the bottom trend line. Regardless of the type of the descending wedge, none of the trend lines can be horizontal in order to distinguish descending wedges from other similar chart patterns. The trend lines must be touched or approached several times by price movements for a confirmation of this type of
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formation. The greater the amount of such occurrences, the higher the likelihood that a breakout will result in expected consequences for the investor. Though volume tends to increase for a descending widening wedge, and decrease for a narrowing descending wedge, this type of volume activity is not considered mandatory for recognition of these chart formations. When a breakout occurs, volume tends to usually be higher than has been demonstrated previously, though this also is not a prerequisite for signal recognition. A widening downward wedge is generally regarded as a consolidation formation, such that the investor is looking for a signal that the established downward trend will continue. A narrowing downward wedge, on the other hand, is interpreted as a reversal pattern; as a result, the trader is looking for a signal that the reversal in trend has started in order to take out a long position. In a widening descending wedge, the investor on the other hand is looking for an opportunity to go short with an anticipated continuation of the established downturn. Trading Strategies As with most chart pattern formations, investors should not contemplate undertaking a position without confirmation that the breakout has occurred. For a narrowing downward wedge chart pattern, this entails penetration of the upward identify trend line, which represents a signal that the reversal is about to occur and a significant upward movement in prices can be anticipated. For widening downward wedge chart patterns, research tends to show that the investor has a greater opportunity of success when a break out occurs on the lower trend line. Though the evidence is inconclusive, for both these situations, if a partial rise or fall occurred prior to break out, depending on the type chart price pattern under consideration, the success for the trade may be diminished. Consequently, the investor would preferably like to see a relatively continuous movement from the opposite trend line when penetration occurs. These types of situations appear to produce the most desired results. Though heavier volume does not appear to be critical for the implementation of a successful trade, a conservative investor may want this type of confirmation before instituting a position. Target prices are similarly calculated for both widening and narrowing descending wedges. One looks for the highest high and the lowest low in the previous trading range. You subtract one from the other to obtain a price range differential. At the point of breakout, this differential is added or subtracted to the penetration price in order to determine a desired target price movement, depending upon which chart formation is under consideration. Though widening descending wedges are viewed as consolidation patterns and, therefore, investors tend to look for a downside break out in order to take a position, there is good correlation towards a successful trade when an upside breakout occurs; however, this is not to the same extent. Should an upside breakout occur, the conservative investor would seek another confirmation signal that a reversal has occurred. The same is true for narrowing descending wedges. Traders normally look for a penetration of the upper trend line to signal that a reversal has occurred, as this statistically has been shown to be the most successful strategy. Opposite breakouts on the bottom trend line, however, may also
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represent a short position opportunity, and these can be contemplated as such with the occurrence of other events in order to confirm that the underlying trend will continue. The positioning of stop loss orders in order to limit losses when formation failure occurs depends upon the nature of the trader. Generally speaking, risk-averse traders will place these types of orders at or just above the original penetration points of the underlying trend lines that were surpassed, while more aggressive traders will wait until the second trend line of the formation has been hit. This second technique results in more frequent positive trades; however, it also produces greater losses when these types of events occur. Compromise strategies can also be contemplated concerning risk management for these types of chart patterns.
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Conclusion Chart formations represent a wonderful way for the astute trader to take advantage of the opportunities available in the assorted investment markets that exist. With that being said, any individual contemplating the utilization of chart patterns in order to make investment decisions should be aware that this is very much an acquired skill that can only be developed through long hours of practice and experience. The overwhelming majority of the traders who use technical analysis tools, such as chart pattern formations, lose money in their investments. Even the most successful traders who use these techniques tend to produce successful results only 40 percent of the time. This is because of the fact that proper recognition of these patterns is difficult, and there is no chart pattern that works 100% of the time. As a result, anyone thinking of using these types of methodologies for investment purposes should always have a risk management system in place that would limit their losses because of misinterpretation of a pattern on their part, or actual chart pattern failure. Both of these situations will arise. However, if the individual has taken the time to develop an expertise in these techniques, then he or she will find that when they have taken the proper position, the results from that position will more than compensate the modest losses that have been incurred, and thus, produce a net result that can be outstanding in nature. There are documented individuals who have used technical analysis tools, such as chart patterns, to amass fortunes in the hundreds of millions of dollars in a relatively short period of time, while starting out with a capital base of only a few thousand. However, these outstanding success stories were people who had an obsessive desire to succeed and were willing to do whatever was necessary in order for them to achieve their desired goals. They had all tested their methodologies and strategies on historical data and were absolutely positive that they could recognize recurrent chart pattern formations. Winning traders in the investment markets have the total confidence that over the long term, they will always be successful. Successful investors in these markets have developed the patience, skills, and experience to wait for the proper point in time in order to undertake an investment. They have developed the ability to discern when not to be in the market, and when to be in the market. In order to be a successful trader utilizing technical analysis tools like chart pattern formations, that person must be able to let profits run and limit losses. In order to develop this ability, the successful investor will have to spend a tremendous amount of time on analysis in order to develop the skills necessary to properly recognize, and not misinterpret chart patterns.
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Mistakes will happen, and a trader must always try to learn from these mistakes in order to allow history to repeat itself. It is equally important to comprehend why the investment was unsuccessful, as it is to understand why any particular trade produced gains. Individuals willing to take the time and effort to carefully understand and recognize chart patterns should have no difficulty in taking advantage of the opportunities that they represent.
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